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PPI Hedonic Adjustments
Posted By Barry Ritholtz On November 16, 2006 @ 6:18 am In Data Analysis,Inflation,Markets | Comments Disabled
With CPI coming out at 8:30 this morning, I wanted to take a few moments to note some of the oddities and aberrations in the Producer Price Index (PPI).
A nagging thought about PPI: It is like a ratchet wrench, one that can only torque in a single direction. When we have Energy price spikes, there’s seems to be no impact on producer prices; yet when Energy prices come down, we see a huge drop. One would imagine these things were somewhat symmetrical (but apparently, not). Something doesn’t compute.
Consider this quandry: How is it possible that prices throughout the entire pipeline, from raw materials to finished goods, managed to stay tame no matter how high energy prices went during the past 3 years? The riddle is answered by observing that government models are gamed to show as little inflation as possible; Otherwise, the COLA obligations  would be going through the roof.
Bill King (of The King Report) makes a similar observation: "Isn’t it interesting that PPI didn’t surge when oil did, but when oil declines sharply PPI plunges?"
Consider his observations on the BLS PPI data:
“Prices for light motor trucks fell 9.7 percent following a 3.5-percent gain in the preceding month. From October 2005 to October 2006, the index for light motor trucks dropped 12.4 percent…In accordance with usual practice, most new-model-year passenger cars and light motor trucks were introduced into the PPI in October. (See Report on Quality Changes for 2007 Model Vehicles, USDL 06-1973.)” Quality changes produce hedonic adjustments to prices. Ergo the large drop in vehicle prices is fiction. It’s the work of BLS bureaucrats, the Winston Smiths from “1984”.
The ‘quality’ or hedonic adjustment to light vehicles is $392.10/vehicle. The BLS reduced the actual costs of these vehicles by $392.10 ERV. For autos the BLS adjusted the real price $139.96 lower. So as we have maintained for years, PPI and especially CPI are constructed so that they can’t show actual inflationary changes or pressure." (emphasis added)
So the anti-inflation question at hand is simply this: Did real prices fall, or was this function of statistical sleight of hand? You may recall the headlines for October Retail Sales noted the role of autos and light trucks: Autos Save Retail Sales From Sharp Decline .
Let’s take a closer look at PPI and Oil (continuous futures contract) again, courtesy of Bill King:
"Economist Bob Brusca on CNBC yesterday noted that the PPI report has light vehicle prices down almost 10%. Brusca added that no one believes this is reality. He added that the index has ‘a problem’ because we have a strong labor market with wage inflation.
The ridiculous PPI reading induced buying of bonds and selling of stocks."
And today, we get CPI. At least we are never wanting for riddles to unravel . . .
UPDATE November 16, 2006, 10:23am
BLS inflation  reporting is what it is. We can take it at face value, or try to figure out what is really going on.
As noted above, I have a problem with the entire "Inflation Ratchet." If its not inflation when energy prices are rising, how can it be proof that inflation pressures are easing when energy comes down? That’s inconsistent.
Look no further than today’s CPI for an example: Apparel was called down 0.7% in CPI, along with the following explanatory BLS note: "Prior to seasonal adjustment, apparel prices rose 1.3%, reflecting the continued introduction of fall-winter wear."
Look at Hotels also, down 0.5%. BLS explanation? “Prior to seasonal adjustment, the index for lodging away from home increased 0.5 percent.”
All Items less food and energy was up but 0.1% on a monthly seasonally adjusted basis. Year-over-year comparisons, however don’t get "adjusted. All Items (ex food and energy) were up 2.6% from October 2005. That’s EX food and energy.
So you can look at the hedonically altered, seasonally adjusted, inflation ex inflation headline spin — or you can look at reality.
If identifying the data before it gets tortured is "zealotry," then so be it. . .
ADVANCE MONTHLY SALES FOR RETAIL TRADE 
Census Bureau, Service Sector Statistics Division
TUESDAY, NOVEMBER 14, 2006, AT 8:30 A.M.
CONSUMER PRICE INDEX: OCTOBER 2006 
Consumer Price Index Summary
U.S. Bureau of Labor Statistics, Division of Consumer Prices and Price Indexes
Article printed from The Big Picture: http://www.ritholtz.com/blog
URL to article: http://www.ritholtz.com/blog/2006/11/ppi-hedonic-adjustments/
URLs in this post:
 COLA obligations: http://www.socialsecurity.gov/cola/automatic-cola.htm
 Autos Save Retail Sales From Sharp Decline: http://www.foxnews.com/story/0,2933,229317,00.html
 Image: http://bigpicture.typepad.com/.shared/image.html?/photos/uncategorized/ppi_and_oil.png
 BLS inflation: http://www.bls.gov/news.release/cpi.nr0.htm
 ADVANCE MONTHLY SALES FOR RETAIL TRADE: http://www.census.gov/svsd/www/marts_current.html
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