What Worries me About “Hedonic Quality Adjustments”

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by Wolf Richter, Wolf Street:

An arcane device that impacts so much and papers over the struggles many Americans face in a world that is becoming increasingly unaffordable for them.

This is the transcript from my podcast last Sunday, THE WOLF STREET REPORT:

For anyone alive today, the US dollar has nearly always lost purchasing power with regards to consumer goods and services, such as food, cars, healthcare, or rent. There were a few brief periods when the dollar gained in purchasing power. But those periods are rare. And the Fed despises these situations when workers are able to buy a little more with the fruits of their labor.

In my lifetime, there were only two such periods, from March through October 2009, and a teeny-weeny bit during the oil-bust of 2015, when energy prices collapsed. During my lifetime, the dollar has lost 90% of its purchasing power. That’s the Fed’s plan, as long as it happens within certain limits.

Now, all this is according to official inflation figures, the Consumer Price Index, or CPI, put together by the Bureau of Labor Statistics. The CPI is critical because it is used for inflation-adjustment purposes across the spectrum, such as inflation-indexed Treasury securities, measures of “real” wages, cost-of-living adjustments for Social Security benefits, or measures of “real yields” or “real returns” on investments or “real” GDP.

But when goods and services get more expensive – and that’s what we’re talking about here – there are two factors involved:

One factor is that the dollar loses its purchasing power, meaning it takes more dollars to buy the same thing over time. A cut at a barbershop used to cost me $15 some years ago. Now at one of the few surviving pure barbershops in San Francisco, a cut is $30. This is inflation, a monetary issue, the change in the amount of dollars it takes to buy the same goods or services over time.

The other factor when goods and services get more expensive is that the quality improves. This is not a monetary issue. And there have been big quality improvements in products such as consumer electronics, cars, appliances, housing even.

These quality improvements are figured into CPI via the so-called hedonic quality adjustments. They’re supported by academic research, and they make sense on a conceptual basis. But when the resulting CPI is used to officially portray increases in the actual costs of living, that’s where everything gets screwed up.

In 1990, the base Camry LE with a four-cylinder engine and automatic transmission came with a Manufacturer’s Suggested Retail Price, or MSRP, of around $14,700. The current 2020 base Camry LE with a four-cylinder engine and automatic transmission comes with an MSRP of $25,000. That’s a price increase of 70% from 1990.

But over the same period, the Consumer Price Index for new vehicles – so this is one of the many subcategories of CPI – has risen only 22%. In fact, it rose 22% from 1990 to 1997, and today is flat with where it had been in 1997.

Obviously, no one pays MSRP. Automakers pile on rebates and incentives, and dealers give discounts. But they also did that in 1990. So MSRP serves as a reference point.

In 2018, the base price of the Camry LE jumped by nearly 5% from the prior year. Toyota figured it would get away with it because it had redesigned the 2018 Camry. The appearance changed. It got longer and wider. Aerodynamics improved. It got more horsepower and torque, new standard features, etc. But in the years before the redesign, the base price remained nearly flat.

On a product-by-product basis, many price increases come in bursts, followed by periods of no price increases.

Toyota jacked up the price of the Camry in 1992, 93, and 94 by 6% to 11% each year, until the base price was very close to $20,000. And that’s where it got stuck. Toyota likely saw resistance in the market, and the price kept bumping into the $20,000 ceiling until, in 2006, it finally broke through.

Then from 2006 through the current model year, prices jumped by 25%. Over the same period, the CPI for new vehicles rose about 4%.

In fact, between 1997 and 2008, the CPI for new vehicles fell by 9%. Then starting in 2009, it rose again and today it is back where it had been in 1997. Meaning zero inflation in new vehicles since 1997.

This discrepancy between actual price increases of new vehicles, and a declining or flat CPI for new vehicles is in part the result of the so-called “hedonic quality adjustments.”

The CPI does not attempt to track by how much the costs of living rise. It attempts to show by how the price of the same thing or service changes over time, to measure a monetary phenomenon, the loss of purchasing power of the dollar.

So in 1990, the Camry LE came with a four-speed automatic transmission and maybe one or two airbags. Today’s model comes with an electronically regulated, shiftable eight-speed automatic transmission and ten airbags. And it comes with myriad other improvements and safety features that were unheard of in 1990, like a backup camera so you don’t run over your dog sleeping behind the car.

These improvements come with additional costs, and estimates of these additional costs are removed from the CPI calculations as they occur over the years. These are the “hedonic quality adjustments.”

The theory is that the vast majority of that 70% price increase of a Camry since 1990 is due to quality improvements, with buyers today getting a far superior Camry; and that only a smaller part of that 70% price increase is due to monetary inflation, namely the dollar losing its purchasing power.

But consumers can no longer buy a new 1990 Camry. If they buy a new car, they have to buy these quality improvements. And they have to pay the price for them. The CPI for new vehicles weighs about 3.7% of the overall CPI.

This principle applies to other product categories as well, such as used vehicles. The CPI for used cars and trucks has declined by 11% since 1995, while the actual prices have surged. Used cars and trucks weigh 2.4% in the overall CPI.

The CPI for computers, peripherals, and smart-home devices has plunged by 75% over the 14 years between 2005 and today. Computers and other electronic devices have gotten a lot more powerful, with a lot more memory and storage space, and numerous new features, while prices have declined.

The CPI for telephone services – so this is your cellphone or landline bill – has dropped 11% over the past 20 years. You may well pay more for your cellphone bill than you did in 1999, but you’re getting a lot more too, whether you want it or not. Now you have a supercomputer in your hand with broadband data access to the internet. Telephone services weigh 2.2% in the overall index.

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