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Sunday, October 10, 2004

Is inflation underestimated?

    Posted by Adam Crouch

Seeking Alpha links to a recent essay by Bill Gross, founder and Chief Investment Officer of investment firm Pimco. This is a guy whose opinion carries a lot of weight.

His October Investment Outlook argues that government statistics are a "con job": they under-estimate the current inflation rate by about 1% and over-estimate real GDP growth by 1%. According to Gross, this explains why consumers continue to borrow to fund spending (real incomes aren't growing), and why job creation has been so weak in this recovery (it's less of a recovery than you think).

Gross says that it's a mistake to focus on "core" inflation, which excludes food and energy. At the end of the day people have to buy food and drive to work, so stripping out sharp price rises in gas and milk is misleading.

Gross says that it's a mistake to focus on "core" inflation, which excludes food and energy. At the end of the day people have to buy food and drive to work, so stripping out sharp price rises in gas and milk is misleading. More important, Gross claims that "hedonic" adjustments to the CPI are a fraud. "Hedonic" adjustments are statisticians' attempt to capture improvements in quality. For example, say the price of PCs declined by 10% compared to last year, but now you get twice as much memory and a faster processor as well. A hedonic adjustment would book a price decline of, say, 25% rather than 10%.

Gross argues that hedonic adjustments to the CPI are a "con job", as they are applied to 46% of the weight of the US CPI with little justification. Hedonic adjustments depress CPI prices for most consumer durables, even including college textbooks.


I can see his point here. If you want to measure the rate of increase of the cost of living, the fact that the standard of living is going up should be baked in. When comparing say 1984 to 2004, you should compare the cost of the typical computer in each time period, not the cost of a 1984-era computer.

Of course, that's just my gut reaction. I have no knowledge about how these hedonic adjustments are arrived at, nor do I know the full and detailed justification for them. Hopefully a fellow econoblogger can enlighten me.

If Gross is right, however, and inflation is significantly higher than we realize, and GDP growth is significantly lower, that's definitely big news with huge ramifications.

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