Consumer Price Index: "I’m Trying To Understand Hedonic Adjustments"
Commended to our attention by Jemima Kelly via FT Alphaville's Further Reading post.
From Epsilon Theory, May 10 (i.e. pre-CPI reporr):
Brent Donnelly is a senior risk-taker and FX market maker at HSBC
New York and has been trading foreign exchange since 1995. He is the
author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.
As with all of our guest contributors, Brent’s post may not
represent the views of Epsilon Theory or Second Foundation Partners, and
should not be construed as advice to purchase or sell any security.
With the intense sturm und drang around inflation right now,
expect the next six months to yield intense hand-wringing and chin
scratching over CPI, PCE and … hedonic quality adjustment. Quite often
when people go to Twitter to rail about CPI, they say something like
“Man, my cost of living doesn’t look like that! My tuition and health
care costs are skyrocketing!” Savvy statisticians then respond with a
flurry of charts that look like the one at right and say “the plural of
anecdote is not data” or something similar.
So all those rising prices are being offset by all those falling
prices and people are just noticing the prices that go up, right? Nope.
The source of the data on that chart is the BLS, the U.S. organization
charged with preparing the CPI data. The data has been sliced and diced
like crazy.
The CPI index is not a cost of living measure! It is a
hedonically-adjusted basket of assumptions that attempts to track some
sort of cost vs. quality / total-utility metric over time. So what
exactly is hedonic quality adjustment? Let’s ask the BLS:
Hedonic quality adjustment is one
of the techniques the CPI uses to account for changing product quality
within some CPI item samples. Hedonic quality adjustment refers to a
method of adjusting prices whenever the characteristics of the products
included in the CPI change due to innovation or the introduction of
completely new products.
The use of the word “hedonic” to describe
this technique stems from the word’s Greek origin meaning “of or
related to pleasure.” Economists approximate pleasure to the idea of
utility – a measure of relative satisfaction from consumption of goods.
In price index methodology, hedonic quality adjustment has come to mean
the practice of decomposing an item into its constituent
characteristics, obtaining estimates of the value of the utility derived
from each characteristic, and using those value estimates to adjust
prices when the quality of a good changes.
The CPI obtains the
value estimates used to adjust prices through the statistical technique
known as regression analysis. Hedonic regression models are estimated to
determine the value of the utility derived from each of the
characteristics that jointly constitute an item.
There is a significant degree of modelling and massaging going on.
The BLS dances around the CPI as cost of living measure question here (see question #9)
and the media often inaccurately describe CPI data as changes in cost
of living. This leads to a situation where people see prices ripping
higher and CPI at 2.0% and it makes them want to yell at CPI.
Since I always think of TVs and cars as goods that have seen flat or
falling prices over the years, I decided to have a quick peek at the
real life vs. BLS-imagined price movements in the world of new vehicles.
I made the arbitrary and grossly simplifying decision to use the Honda
Accord and the Ford Mustang as my cars because they have been popular
for more than 30 years, there is plenty of historical pricing data, and
their target demographics and brand image haven’t changed much over
time....
