Inflation rates have been generating headlines, moving markets and inflicting pain on households for some time now. Following further interest rates rises from the Bank of England in earlier this month, it might come as a surprise (or perhaps not!) to learn that, thanks to some statistical manipulation, the true level of inflation is consistently higher than published CPI rates.
A little-known component of many governments’ official inflation figures is their application of hedonic adjustments. This aims to take account of a change in quality of any component within the basket of goods used to calculate the CPI, by discounting (or inflating) the price of that component to reflect any change in “quality”.
Let’s consider the example of a new smartphone. The sticker price may be 10% higher than the previous model, but when adjusted to take account of its faster processor, bigger and higher resolution screen, better camera, etc, its value within the basket is barely changed.
Another example is a new car. Its more powerful and economical engine, enhanced driver aids, new regenerative braking system and improved infotainment package all have a value ascribed to them, which are then deducted from the new nominal price to arrive at the “true” rise in price.
In fairness, other adjustments also work the other way. For example, the fact that the size of Mars Bars and Cadbury’s Creme Eggs, or the contents of smoky bacon crisp packets seem to be shrinking by the year (how annoying is that, by the way?) means that their prices are adjusted upwards when the stats are calculated.
For the most part, however, technological advances in all electronic goods (according to Moore’s Law, processing power doubles, and therefore its cost halves, every 18 months), along with the likes of broadband services, medical care, cinema tickets, computer software, far outweigh the impact of smaller Chocolate Digestives on the average household.
So far, so what? I hear you ask. Why does this matter? Well, firstly, progress in unavoidable – let’s face it “NEW AND IMPROVED” tends to crop up in manufacturers’ sales blurb a little more often than “not as good as our last one”. Second, as consumers, we have no choice other than to pay up for new stuff – we simply can’t buy the older, cheaper model, even if we really wanted to.
So why bother with hedonics at all? With large chunks of western governments’ expenditure items linked to the CPI – welfare, pensions, public workers’ salaries, interest on inflation-linked bonds – there is a clear incentive for governments to do whatever they can to supress the official rate of inflation by as much as they can.
With this in mind, it is perhaps unsurprising that information on the effect of hedonics is difficult to come by. A trawl through the UK Office of National Statistics’ website offers a list of the electronic goods to which they are applied and an example of the method and calculation (tellingly perhaps, this reduces the nominal price rise of 16% for a desktop PC to a decline of 2%!1). Meanwhile, the US Bureau of Labor Statistics reveals only that 33 of the 273 components in its CPI basket are subject to hedonic adjustments. Neither organisation, however, disclose the extent to which the data is affected.
Whereas the implication is that such price adjustments have a negligible impact on inflation numbers, typing in “hedonics” to your favourite internet search engine will find no shortage of commentators and conspiracy theorists who say otherwise. Indeed, credible estimates of the quantum by which price indices are reduced range from of 0.5% to as much as 2% per annum over and above of the official inflation rate. Even in the middle of that range, the effect of compounding over the long term – both in terms of savings in governments’ expenditure and additional pain in our purses or wallets - is not insignificant.
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