Price Indexes (1) Hedonic Histrionics

From time to time I come across articles about the use of hedonic methods in price indexes. The topic is popular among conspiracy theorists and the Consumers Price Index (CPI) produced by the US Bureau of Labour Statistics (BLS) seems to draw the most heat. Changes in the methods used in the CPI are often portrayed as part of a government cover-up.

Economists get quite stirred about this issue too and often perpetuate confusing ideas about something they do not fully understand.

The PPI has clearly been insufficiently adjusted with hedonics, chain-weighting and rental equivalence (Stefan Karlsson).

Then, when one adds in hedonics, which strips out many price increases by assuming they are quality improvements, and when one factors in the substitution allowances in the data, it is clear that the CPI is not going to flash any sort of alarm bells (Bill Fleckenstein).

One problem that makes the discussion confusing is failure to distinguish between two terms: “quality adjustment” and “hedonic adjustment”. Quality adjustment is a practice used in most price indexes. Hedonic adjustment is just one among a variety of methods used for quality adjustment.

The BLS did not introduce quality adjustment when it started using hedonic methods in the 1990s. It has used quality adjustment as long as it has produced price indexes (I will explain why in a later post). The change made in the 1990s was to introduce hedonic methods to quality adjust a few commodities, where the BLS was unhappy with other methods of “quality adjustment” (Brent Moulton).

More on this in the next few posts.