How Much Does The CPI Understate Inflation?

Submitted by The Consumer Price Illusion

Estimating the Effect of Hedonic Quality Adjustments on the Consumer Price Index

Having an informed debate over Hedonic Quality Adjustments is difficult due to the lack of comparable consumer price indices. A few exist, however, and 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 (CPI included for comparison):

Since starting calculation of the index in mid-2008, PriceStats inflation series has remained consistently above the CPI as reported by the BLS. 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. Currently, the CPI uses quality adjustments on over 32% of the items used in its calculation.

Annual inflation figures show a similar story, occasionally showing divergences greater than 1.5% in the two measures of annual inflation:

In addition to being used as a benchmark for policymaker’s worldwide, CPI’s influence a myriad of payments:

  • calculating cost-of-living adjustments to social security and federal retirement programs,
  • calculating payments on over $700 billion worth of inflation protected securities (TIPs)
  • determining pay-bands in public and private entities
  • cost of living adjustments to collective bargaining agreements
  • determining IRS tax brackets and numerous tax-related levels (exemptions, for example)
  • Basic CPI indices feed into the PCE price index which is the preferred measure of inflation by the FOMC

Overall, CPI’s are used to index payments on over $10 trillion in liabilities. Any underestimation of  CPI benefits the federal government at the expense of the taxpayer and amounts to a backdoor default on its financial obligations. Please understand this could be deliberate or the result of dubious econometric methods. Using a bad model is like using a random number generator as a compass.

To get an idea of the sums of money involved, for every 1% of CPI underestimation the federal government saves $8.4 billion on social security payments aloneThe lack of transparency regarding quality adjustments (and their perceived complexity) provides a perfect smoke-screen for covert debt management through CPI under-reporting.

There is no reason for this to be the case. Hedonic Quality Adjustments are computed via linear regressions, one of the least complicated models in statistics. Any statistician provided with the data could verify the BLS’s regressions using an off-the-shelf statistical computing package like R. Release the data, plain and simple; any other response smacks of corruption in the name of regression or an attempt to justify one’s existence.