Your personal inflation rate

I have long railed against many of the absurdities associated with modern Inflation reporting. Let’s take a closer look at some of the specifics:

Start with the inherent bias built into the BLS models, and their tendency to understate inflation. Next, add a sprinkle of substitutions, quality improvements, and hedonic adjustments, all of which rationalize price increases as somehow non-inflationary.

Then, we have the Fed’s focus on core inflation, which tends to ignore the non core items like Food and Energy (besides, who really needs Food and Energy anyway?). A variation on Core Inflation is Wall Street’s love affair with Inflation -ex-inflation, which is a basket of only those goods and services that have not gone up in price.

Finally, the latet inflation innovation is a new concept I call Uni-directional Inflation, which states that when certain items (e.g., Oil, Corn, Copper) go up in price, it is not inflationary — but when those same items drop in price, its proof positive that inflation has been vanquished.

We discussed a few of the differences last week between US and UK inflation data in "The Sordid Truth About Inflation." By the time the UK inflation arrives here, its so tired by its swim across the pond that it cant move the BLS needle at all.   

Let’s take a closer look at two of my favorite inflation data absurdities, Substitutions, and Hedonics:

Substitutions: There have been numerous academic approaches to this subject. See for example An Expert System for Reviewing Commodity Substitutions in the Consumer Price Index (BLS), or the Testimony of Fed Governor Edward Gramlich on Improving the consumer price index. They are mostly exercises in futility.

Its one thing to try to understand consumer behavior in the context of the real world, In the real world of finite budgets and price sensitve consumers, substitution is an actual consumer behavior. However, its another thing entirely to pervert this behavior and offer it as proof of less inflation. Its nonsense.

When someone buys Chicken instead of Steak because meat has gone up in price, that’s evidence of inflation. The substitution process fraudulently rationalizes this to eliminate inflation from the BLS basket. Indeed, substitution is PROOF of inflation. When a product’s price rises out of a consumers ability to afford purchasing it, its prima facie evidence of inflation. Only the starry eyed residents of ivory towers can say with a straight face that cheaper substitutes are non-inflationary.

When consumers engage in substitution, they are explicitely acknowledging inflation. Incidentally, the intellectually dishonest sleight of hand of substitution is courtesy of the Boskin Commission


Hedonic Adjustments:  Hedonics asks the question: "How much of product’s price increase is a function of "inflation," and how much is a quality improvement?" Thus, the entire late 1990s concept of Hedonics is premised upon a flawed assumption: that Quality is static.

In reality, all products incrementally improve over time. Indeed, it is the very nature of all technology — from fire to the wheel to the iPod — that they become better/faster/cheaper/feature-laden over time.

Rather than claim this as non-inflationary proof, I say instead it is evidence of mankind’s genius. Other than a few centuries when religous zealots prevented it, our entire history is one technological progress. We make things, then we make them better, then someone else improves upon them, on and on and on. It is the natural order of things

The theory of Quality Adjustments is flawed at best. To claims inflation is overstated due to improvements reveals a misunderstanding of the essence of human inventiveness, as change and quality improvements are part of our very nature.

Hedonics are the bastard stepchild of flawed assumptions and abstract theory. To call it dishonest serves only to slander liars. Consider:

"Hedonics opens the door to producing magical results: a lower inflation rate with generally rising prices, a higher growth rate although the economy may be weaker, and a higher productivity number, although productivity would have been declining without the hedonic imputations."  —The Illusions of Hedonics

Nice trick.

We should not confuse inflation with industrial economics of scale. Early versions of products cost more because the first units are manufactured in small batches, with much of the R&D costs included. As any product moves from the early adopters towards the mainstream, prices decrease, quality and functionality improves, commoditization occurs. This is to be expected.

For example, take ABS brakes in the past, or Dynamic Stability (or Traction) Control in the near future. When these first were introduced, they were expensive options. As time progressed, the chips that make these possible dropped in price. Now, they cost so little that its standard on every car (DSC is mandated to be on every car in the future). Same with Airbags. Indeed, soon you will not be able to buy a car without both of these (and nearly every new vehicle today comes with Airbags and ABS).  You won’t be able to "substitute" the cheaper version if you wanted to.


Hedonics is a variation of the old trick of comparing the present with the past, instead of the present. Measuring quality improvements is a distraction from the real measure of inflation: the purchasing power of a dollar.

Does your money still buy you an equivalent vehicle (i.e, middle of the product line) for an equivalent amount?

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  1. Mike M commented on Jan 23

    “Rather than claim this as non-inflationary proof, I say instead it is evidence of mankind’s genius. Other than a few centuries when religous zealots prevented it, our entire history is one technological progress. We make things, then we make them better, then someone else improves upon them, on and on and on. It is the natural order of things”

    Excellent! This is the result of capatalism and private ownership, two things which are in decline in America.

    In a capatalistic economy with a currency that is an actual store of value, prices of almost all goods would slowly fall over time. This raises the living standard of everyone in the society.

    Unfortunately, the dollar is no longer a store of value and our private property laws are weakening (the two are related).

  2. Leisa commented on Jan 23

    All of this reportage using ridiculous bases makes me ill. I’m an average consumer. I marvel that I can buy a stainless steel table at Costco for $100. I also marvel that milk, cereal and butter have gone up dramatically of late. Corn prices escalating? Isn’t that what chicken’s eat and what goes into cereal and grain fed beef. Who’s fooling whom keeping energy and food prices out.

    And even though I am an infrequent consumer of medical services–meaning my costs are a fraction of my annual premium, and we’re not on any prescription drugs (though some might credibly argue that we SHOULD be!) we have among my family of 4 maybe a dozen visits per year to the doctor–my premium went up about 20% on renewal.

  3. Andy commented on Jan 23

    If the price of haircuts goes up because the Fed is printing too much money, then the Fed should slow down the money machine. If the price of oil goes up because investors are worried about geopolitics, that doesn’t mean that the Fed should tighten. Do you really think the Fed should have raised interest rates in mid-2006 to fight off oil inflation? and it would have done anything good? The Fed worries about core inflation because that what it can control, at least to some extent. If you find that it isn’t useful for your own life, fine, but why attack the Fed for that? I assure you that your medical premiums are going up for reasons far beyond the control of the Fed, so direct your anger somewhere more productive.

  4. Mike_in_FL commented on Jan 23

    My personal pet peeve with the Fed’s inflation approach is its complete unwillingness to consider “asset inflation” in any way, shape, or form.

    Take housing. Anyone with half a brain could see actual, real world home prices were soaring in 2002-2005 far beyond what the fundamentals (economic growth, household formation, median income growth, etc.) would dictate. But the Fed rationalized it away by saying that homes were assets rather than a form of good, like the stuff that goes into the Consumer Price Index (Indeed, the actual prices people pay for houses do NOT influence the housing component of the CPI … owners’ equivalent rent is the big contributor there). So what happened? The housing bubble kept expanding before starting to burst in late 2005/early 2006, with consequences we’re still dealing with today.

    The fact is, when too much money is flooding the economy, it’s going to show up somewhere in the inflation food chain. Whether it drives up wages and goods prices, a la the 1970s, or drives asset valuations to ridiculous levels (housing prices in 2002-2005 and, I’d argue, commercial real estate prices now), it shouldn’t matter if you believe inflation is always and everywhere a monetary phenomenon. Get credit and money growth under control and you won’t see these rolling asset bubbles.

    I did my best to deconstruct the Fed’s “hands off asset prices/asset price bubbles” view, as laid out by Fed Governor Mishkin a few days ago, here:

  5. M.Z. Forrest commented on Jan 23

    Inflation is still a monetary phenomena. I’m very sypmathetic to angst over substitutions, but it at least is an organic phenomena. Say we have a rough winter and cattle population drops due to increased feed prices. We will have increased beef prices. It won’t be inflation. (BTW, pork has seemed to drop off a cliff at the stores.)

    I very much agree that hedonistics makes the inflation measure worthless. If they want to come out with an inflation number and a hedonistic adjustment number, then I’m sympathetic. Anything that has an obsolescence schedule of less than 10 years should never be hedonistically adjusted. Yes, I would find it useful if hot water boilers are cheaper after adjustments. I don’t care if a 27″ TV is. If a 27″ TV isn’t cheaper, then I’ll buy a 25″. Whoppee.

  6. Fred commented on Jan 23


    The LEI just came out at +.3% vs exp .2%.

    Do you have the same concerns with these numbers, or do you trust them (as is)?

    I have always dismissed the gov’ts inflation data as it is coincident *(as well as “massaged”).

    I hold the leading indicators as much more important in my work — FIG, LEI, etc.

    I like what they are telling us…even if it means rate cuts are not imminent.

  7. Idaho_Spud commented on Jan 23

    I’ll take that ’67 Tri-Power Stingray for the list price of $4795.

    Shouldn’t be worth anywhere near as much as a new one. No airbags, ABS, or traction control.

    And I will accept no substitutions either.

  8. js commented on Jan 23

    The Fed is doing well in containing the price of the haircuts etc. However, they are using the questionable techniques that Barry mentions to justify easy (or now neutral) policies that are inflating bubbles all over. The fallout is going to be unpleasant (like the stock mkt fall earlier this decade).

    Oil prices that are not controlled by the Fed also affect the prices of other goods. By not heeding to the potential dangers of indirect inflation from commodites, they have demonstrated bad judgement in the 70s. The Europeans did much better in that episode of commodity price spikes with a better monetary policies.

  9. metroplexual commented on Jan 23

    “Hedonistics” LOL. The basics should be part of the inflation #s, healthcare, food, transportation, fuel, etc.

    While my new computer is faster than my old one and yet when I bought both they were just as adequate for word processing. My 8086 was good for spreadsheets as was my i486 and my pentium III. Each was perfectly good for its time yet each time it is better. I would be horrified if my work computer was an 8086 now buthow do you measure that?

    While quality of life aspects of hedonic measures are just arguing how many angels can dance on the head of a pin imo.

  10. Charles Butler commented on Jan 23

    Simplify the whole exercise and look at the savings rate. It makes the U.S. look like a nation in the throws of poverty and/or hyperinflation. If a society as a whole cannot save any money, then it is arguable that the cost of sum of what people think they need (if it includes a 42″ flat screen, so be it) has inflated itself beyond the limits of their incomes. Is there anything else we need to know here.

    What is the interest rate level that will make people save money? Would it be anywhere near that which puts an end to extreme asset price inflation? And would you be able to deduce a real inflation rate from it? Likely so, I say, on all counts.

  11. js commented on Jan 23

    I think that the adjustments for quality are highly suspect. I got a 27-inch TV in the mid-90s for around 400. Recently I got a 32-inch LCD (pretty much the same size as the 27″ given that it is 16:9 aspect) for 1200. Given that the resolution is higher – 3 times the pixels – the quality is 3 times as good. I buy that. I paid 3 times the money. So, it is a wash. Inflation should be ZERO. How does the BLS claim that prices fell by 70% over that period? How is the price down so much? Are they counting the inputs available? Or is it some other subjective measure? It is interesting that Europe does not engage in such questionable quality adjustements and their inflation rate is lower regardless.

  12. costa commented on Jan 23

    pay phones cost $.50 and gum is $.30 thats inflation

  13. Wes commented on Jan 23

    Another thing hedonics doesn’t address is executability. If this year’s 32″ TV costs 5% more than last year’s model, but the BLS deems the new model has a 5% improvement in quality and therefore 0% inflation occured, the consumer doesn’t have the choice to purchase last year’s model. If he wants a 32″ TV, he’s spending 5% more dollars out of this pocket, period. In a world where no other 32″ TV option exists, that’s inflation.

  14. Don Lloyd commented on Jan 23

    If the supply of money were not increased, then quality adjustments could only affect relative prices, not an overall price level.

    Pick one good and increase its quality so that its market price is increased by 10%. Then recursively increase the quality of all other goods so that the individual market prices of all goods and services are in the same ratio as before any quality increases were instituted. If there has been no increase in the supply of money, it will be largely true that all market prices will have returned to their original values. All goods and services will be of higher quality, but the dollars required to make purchases will be just as high as ever, and will rise with an increase in the supply of money just as if the quality increases had never occurred.

    Regards, Don

  15. Robert Coté commented on Jan 23

    How about hedonic adjustmets to education based on quality and productivity? Princeton did not raise tuition for next year for the first time in decades BUT room&board are rising substantially. I’ve mentioned before that Harvard could save money by not charging tuition as the costs of administering exceed revenues. I remember the flyers all over the campus announcing weeks in advance the “spontanoeus protest of MIT’s large and unexpected cost increase.” And the Cal Univ/State system. Tution is free per the State Constitution but “fees” now that is another story. Paying 10x as much as 30 years ago with a henodic adjustment for quality of 1/2 and a productivity adjustment of 4/5ths and higher education alone exceeds the entirety of all inflation the BLS/CPI pretends to have occured.

  16. metroplexual commented on Jan 23


    That is where they are increasingly turning to for revenue. It is the old trick of being able to state a truth of no tuition increase but everything else goes up. My old state university would do that all the time.

  17. Steve C commented on Jan 23

    I have often thought a better way of including the volatile components of the inflation index (food, fuel, sometimes housing) would be to include those parameters as 4 or 5 month moving averages of their values to smooth out the spikes.

  18. JoshK commented on Jan 23

    I don’t think this is the first time someone has criticized the CPI calculation methodology. I’m not sure myself of the best way to do it. But, you’re not being fair to ignore all hedonic adjustments. While it may be difficult to say percentage-wise how much more new car you are getting today, you can’t ignore the fact that when you buy a Civic today you get a better car than a high-end Cadi back in the 70’s.

  19. Eddie commented on Jan 23

    IMO, there are two basic causes of inflation.

    Type 1: The prices rise because people have more money and they’re spending more and the vicious circle starts.

    Type 2: External costs rise on imported basic materials (oil, metals, etc) pushing up the manufacturing costs of everthing built from there. This naturally gets passed on to consumers.

    The fed may only have an effect on Type 1. Type 2 is beyond the control of the US Fed (we cannot control worldwide demand for natural resources), and therefore any price increases that come from this should be ignored when it comes to policy decisions.

    Perhaps this is why the numbers get ‘cooked’ so much… To filter out this Type 2 inflation.

  20. Don Lloyd commented on Jan 23


    I don’t think this is the first time someone has criticized the CPI calculation methodology. I’m not sure myself of the best way to do it. But, you’re not being fair to ignore all hedonic adjustments. While it may be difficult to say percentage-wise how much more new car you are getting today, you can’t ignore the fact that when you buy a Civic today you get a better car than a high-end Cadi back in the 70’s.

    That’s beside the point. The standard of living and the cost of living are separate things. The use of the reported numbers to adjust entitlement payments makes the subjective improvements in the standard of living irrelevant. You still have to pay market prices for what you buy, no matter how much the available goods have improved in subjective quality.

    Regards, Don

  21. brion commented on Jan 23

    “you can’t ignore the fact that when you buy a Civic today you get a better car than a high-end Cadi back in the 70’s.”

    I just went shopping for a washer yesterday. Very similar workmanship in the entire 5-600 $ range… (crap).

    To get a machine whose crucial components weren’t made of the cheapest plastic this side of Shanghai cost at least a Grand….The Model name of the washers i was looking at?
    The “Elite” series. (lol)

  22. js commented on Jan 23

    I wonder what happens to goods whose quality actually goes down. Christmas lights now cost less but don’t even last one season. How are dips in quality handled?

  23. Teddy commented on Jan 23

    Has anyone been in an accident with a new Civic? My advice. Slow down!

  24. Teddy commented on Jan 23

    The housing market’s state of the state, described as a “cyclone spin of a toilet flush”, was interrupted by analysts’ positive upgrades this morning. Was this just some toilet paper blockage or was it a reverse spin block by the new refi mortgages whereby the homeowner can delay making payments for 12 to 36 months (see BR’s blog on Jan 10 for article)? IMHO, to continue a soft landing approach and no bubble prick, we need an increase in negative savings and a fairly healthy housing market.

  25. RMX commented on Jan 23

    Interesting too, that when inflation shows up in financial or real asset prices (equities, houses etc.) it’s “no problem”. But God forbid if it starts to show up in wages.

  26. donna commented on Jan 23

    Pork can go ahead and drop off a cliff for all I care. Smithfield should be out of business.

  27. RMX commented on Jan 23

    And does anyone know if the UK Treasury issues their own version of TIPS? Just curious. Always thought this was a great idea, in concept, for some inflation protection but I have no interest as long as the US government gets to determine the inflation rate.

  28. jasper emmering commented on Jan 23

    It is interesting that Europe does not engage in such questionable quality adjustements and their inflation rate is lower regardless.

    Alas, no longer. The different national agencies are switching to hedonics when they report to the European agency. Although they might continue to publish their own data using their own methods.

    And yes, what about losses in quality? I don’t recall spending two days downloading and installing different drivers, e-mailing and calling helpdesks, and banging my head against the wall in desparation back when I used a typewriter instead of a printer.

  29. js commented on Jan 23

    I looked it up. Looks like you are correct. The US is just far advanced in our use of hedonics. Thanks for bringing it up.

  30. Mr. X commented on Jan 23

    The important element that inflation measures do not include is GW (not George W Bush, but global warming).

    In 1500 AD there were 3/4 billion people on the planet; in 1930 there were 1.5 billion; in 2007 there are 6.8 billion. Extrapolate that out if you can (hint: exponential). All of this growth in bodies is driven by energy, ie. cheap, abundant fossil fuels. Unfortunately they are finite, and good clean, light oil production has peaked and is now in decline. Yes, we have heavy, sour crude, yes we have oil sands, yes we have oil shale, and yes we have coal, but we are paying the price to dig this junk out of the earth and to refine it.

    That price, in terms of GW and air quality, etc is not part of the CPI, but it bloody well should be, because sooner (more likely) or later we will pay a monetary price to stop polluting the atmosphere and either slow or stop GW so that we can provide a future for the fruit of our loins.

    So we merrily roll along, thinking oh wow, what a wonderful world, we’ve got China, India, Brazil, Viet Nam, etc.etc.etc. to provide the cheap labour so that we can continue our profligate spending on cheap imports, and live forever at a low inflation rate. But there are costs associated with every country in the world having the ability to set up manufacturing plants ultizing cheap energy and cheap labour.

    But Greenspan and Bernanke give absolutely no consideration to these costs, because it might upset the markets! (and their political masters). The day of reckoning is coming however, and the first politician to twig into this, well, I”m going to endorse and vote for him/her.

    Screw hedonic adjustments and substitution, these pathetic adjustments pale in comparison to the cost of global (in the true sense of the word) warming.

  31. Si commented on Jan 23

    Nice one Mr. X, Its about time saving the damn planet became factored in to all this stuff. Have started to reduce my exposure to the markets, I figured that I don’t want to be part of the money machine killing it. However I have absolutely no faith in policy makers worldwide in dealing with this issue, for a couple of reasons, the choices are too big for these morons to deal with and most of them are as dumb as a brick.

  32. DavidB commented on Jan 23

    Pork can go ahead and drop off a cliff for all I care.

    Clearly you are not the type of person that ‘brings home the bacon’ donna (;

    As for hedonics, didn’t that, at least from a business perspective, once get called productivity?

  33. my1ambition commented on Jan 24

    OK, trying hard to decipher a code which not many seem to fully understand (hence, the constant Inflation/Dis-inflation Battle between the Mish’s and the Barry’s)…

    I believe we are left with two possible scenarios…

    1. Inflation – should be read “Credit” – has been filtered into the money supply giving businesses the financial ability to expand with increased invested – read “credited” – dollars and has been able to afford to bring the price of products down to levels that the consumer could afford.

    In other words it is not inflation for the consumer but an increase in credit and liquidity for the supplier.

    This will cause for an inevitable bust in the markets when earnings are no longer sustainable, investors cut back and the entire economic cycle tightens

    This has little affect on the consumer since the “inflation” only led to corporate/Hedge Fund profits and yacht sales, not wages and income.

    2.There truly is “Inflation” in the cards and it is in the process of being transfered over to the consumer.

    Et al, the Fed will keep expanding the money supply – which many think is both improbable and impossible due to the falling complacency to lend as we see so far from the many sub-prime lenders falling under by the week.

    In either case short-term rates will be insignificant – in scenario #1 rates, even if brought to Zero will have little effect on the decades of credit and “liquidity” that have been ever-increasingly been pumped into the market.

    In scenario #2 – Hyper-inflation is in the cards and the Fed will be chasing inflation instead of preventing it in the same way they were in the 70s.

    So is it 1929 or 1970 all over again? It only depends on how long the madness will last.

    How long will that be? Many say not long at all.

  34. Teddy commented on Jan 24

    My1ambition, loans are still being made since the money supply (total credit) is up 10% in the year and still steadily rising. Somebody besides credit card companies and refi companies are clearly handing out debt. Bernanke and Wall Street are counting on an increase in negative savings to keep this bubble from being pricked.

  35. rex commented on Jan 24

    Barry: I think you don’t understand inflation. It’s a GENERAL increase in prices, as opposed to relative price increases.
    A general increase in prices means there’s too much money, so the Fed tightens. But if there are relative prices increases, it means that supply and demand are working in a particular market.
    For instance, if beef prices go up but chicken and pork and tofu and venison prices don’t, that’s NOT inflation. It’s just supply and demand working in the beef market to send price signals to buyers and sellers. Sellers are told: Make more beef! and buyers are told: Buy less beef!
    I’m not sure what you are complaining about anyway, because the CPI doesn’t really capture any substitution effect except over a period of years. The CPI market basket weights are fixed.
    And your rant against hedonics is puzzling considering you are such a gadget freak. If manufacturers introduce a bunch of cool new features but don’t raise the price, that’s actually a price cut to you (as long as you value those cool new features). You get more for your money. It’s progress, not inflation!
    I understand that it’s hard to adjust for quality in practice, but I can’t see anything wrong with the principle. Consumers buy products for their utility. An LCD HDTV at $1,000 is a much better buy than the 24″ cathode ray black and white set my parents bought for $750 back in 1950. But the “Big Picture CPI” you advocate would say the price of a TV has gone up 33%. That’s plainly dumb.

    Barry: Don’t be such an ideologue on this issue. It goes against everything you’ve ever written about being smart with your money.

  36. Teddy commented on Jan 24

    The reality is that what we fail to resolve, we are destined to repeat.

  37. Barry Ritholtz commented on Jan 24


    What I am criticizing are specific flaws in the way the CPI data is processed, and the many ways BLS has to show that price increases are non-inflationary.

    I understand that inflation is primarily a monetary phenomena. What I am kvetching about is hiding the effects of that.

    Lastly, as to the gadgets, and other improvements in quality, I EXPECT these things to improve as part of the natural order of progress. The fact that KIng Arthur had a “bucket,” and we have indoor plumbing isn’t proof of non-inflation, its proof of a rising standard of living.

    Your parents had 3 channels and B&W TV; We have 500 channels, TiVo, Video iPods and Hi-Def wide screen plasmas

    In my view, that improvement is inevitable. Regardless of what the Central Bank does, these improvements would have happened anyway — they are irrelevant to inflation and monetary policy . . .

  38. cm commented on Jan 25

    And among the 500 channels, there are approximately 3 that you want to watch. Granted, those are probably not exactly the same 3 for everybody …

  39. Jay Weinstein commented on Feb 18

    I greatly enjoy the site, and would appreciate your comments on the following:

    “If 5 years of inflation fall in the forest, do they make a sound?”

    What I mean by this cryptic remark is as follows:

    One of my favorite pastimes is asking any random person at a cocktail party what they think inflation has been over the past 5 years. Usually, the answer runs between 5-7%. When I tell them that the government statistics show an average of under 2% for that time frame, they simply laugh it off as absurd. And as you have pointed out time and again, the government data is in fact absurd.

    I do believe that inflation has slowed from the 2001-2005 period though. So my remark can be translated as follows: I believe that the inflation of the early part of the decade never was and never will be truly captured in the government statistics. What effect, if any, does that phenomenon have on the economy and markets going forward?

    Best regards.

  40. Hugh Martin commented on Feb 25

    The BLS inflation numbers are absurdly low. It’s one huge scam, a lie, partnered with another scam, the absurd expansion of the money supply which is devaluing the dollar and will lead to its total collapse. Why would the US government directly contradict the best interests of American citizens? Because it no longer works for us; we no longer control it. Big money controls the government, and nearly everything the government does is for the benefit of the ultra-rich ruling elite that deliberately remain hidden behind the charade they so carefully nourish.

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