Thursday, 13 November 2014

So just how much do “adjustments” adjust down the CPI? [updated]

The Consumer Price Index (CPI) is used as a benchmark for policymaker’s worldwide and influences trillions in payments, including:

  • calculating cost-of-living adjustments
  • deciding on central bank interest-rate rises, and changes (or not) in LVRs
  • calculating payments on inflation-protected securities
  • determining pay-bands in public and private entities
  • cost-of-living adjustments to collective bargaining agreements
  • determining tax brackets and numerous tax-related levels (exemptions, for example)

Since economists are largely concerned with “real” prices (actual prices scaled by inflation as measured by the CPI), any error in the calculation of real prices introduces a bias that propagates to every corner of economic thought. This is a central flaw in economics that largely explains the gap between actual human experiences (“Wow! Things are expensive!”) with central bankers gambling our collective future on fighting “deflation.”

Yet while just a 1 percent difference in the CPI makes a trillion dollar difference in these changes and payments, the adjustments made in calculating the CPI are too often simply taken for granted.

The biggest change is probably what’s called Hedonic Quality Adjustments, wherein raw price data is manipulated so that  large increases in the actual prices of certain products can be transformed into decreasing prices when calculating the Consumer Price Index – and even a 400% price increase can be transformed into a 7.1% Decline.

So just how much do “adjustments” adjust down the CPI?

… today we will look at an index compiled by PriceStats, an off-shoot of MIT’s Billion Prices Project, which scrapes the internet for prices and compiles a daily index that aims to track inflation in real-time.
    The time series eschews
hedonic and seasonal adjustments and relies on sampling over 5 million products to produce a very different look at inflation (US official CPI included for comparison):

Since starting calculation of the index in mid-2008, PriceStats inflation series has remained consistently above the official US CPI. Considering the differences in methodology this provides an estimate to how much Hedonic Quality Adjustments have been used to understate the head-line CPI figures.

UPDATE: To keep the perspective on just how much the price of technology is falling – how dramatic the fall -- check out the cost of computing power equal to an iPad 2 through the decades:

Graph showing the falling cost of computer power

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