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Fun with Hedonics or:
How I learned to stop worrying about CPI and love inflation.”

Posted By Barry Ritholtz On April 21, 2004 @ 10:40 am In Finance | Comments Disabled

An anonymous friend poses the following question regarding the official CPI/inflation stats:

Question: What do you think official, “real GDP” growth would look like if they were forced to back out an honest CPI number? That’s a laugh in itself, eh? How much of a COLA would the government be forced to grant the nation’s retirees if CPI went legit all of a sudden?

That’s an interestingly loaded question. The implications of it are quite significant, especially when you are trying to gauge whether the markets’ are appropriately reacting or overreacting to Greenspan’s testimony.

Consider what happens if/when rates increase sharply: The mortgage/refi/housing industry slides back to a normalized rate, removing an enormous source of economic stimulus from the broader economy. Regardless of the fact its an election year, that fear is enough to deter the FED almost indefinitely. This has led my pithy friend to observe, “No wonder they have so much patience!”

But how can they manage to keep the CPI so low, when all evidence points to a inflation? We know China has been consuming enormous quantities of commodities, while domestically, we have historical levels of stimulus. Why isn’t this showinng up in CPI stats?

Again, let’s go to my snarky friend:

“Between seasonal adjustments, hedonics and geometric approach, we don’t ever have to see a rip-roaring CPI. If a head of lettuce went to $40 bucks overnight, they could seasonally adjust it lower in a heartbeat by claiming that we had an unusually rainy summer. They could then signal that the lettuce is genetically improved and as such there is a quality issue here which lowers that price considerably. As a last resort, here come the geometrics where they could just underweight food to whatever minor influence they want it to have.

Voila, that $40 buck head of lettuce really cost you 29 cents. Of course, this is part of the “volatile” (which currently means one-direction, up, these days) food and energy categories which are completely ignored, owing to their unpredictable nature. This has given rise to the perfect excuse, the core rate, which at present is officially honky-dory. But you can apply the same insanity to any item. Go on. Pick one. See what I mean? Sheesh.

Bottomline: If the Fed is intellectually honest, we should be seeing rate increases already.

My apologies to Stanley [1].


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[1] Stanley: http://www.imdb.com/title/tt0057012/

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