What if an apple were an orange: quality adjustments in the consumer price index

The core Consumer Price Index (CPI), which excludes food and energy prices, unexpectedly dropped 0.1% month-over-month in March. Price declines were broad-based from apparel to new and used cars. But one category stood out as a significant outlier; there was a 7% drop in the cost of wireless telephone services. This was the largest drop since the data started being collected in 1997. In reality, the core CPI would have been flat excluding the wireless plan pricing.

This is somewhat of a big deal for a couple reasons. Let me explain. Wireless companies are in a price war. Companies have brought back unlimited data plans and cut prices on those plans to woo customers. These lower prices are being picked up by the CPI. But, the Bureau of Labor Statistics (BLS), the government agency that computes the CPI, also changed their methodology as it relates to wireless plan pricing. The changes had to with something called quality adjustment.

Why does quality adjustment matter?

If you remember from Macro 101 class, the CPI is derived from prices of a fixed basket of goods and services. The BLS measures inflation by tracking the prices change for that basket. The rub is that, of course, as technology evolves, so too does the basket of goods and services. When one good replaces another good, the prices are not directly comparable. Economists must tease out how much of the price change comes from true inflation and how much is due to changes in quality. For example, when plasma TVs replaced good-old-fashioned cathode ray tube TVs, the BLS estimated how quality change affected the pricing of plasma TVs. In other words, they modeled the price of plasma TV, if it was included in the basket of goods in the past.[1] The key here is that quality is deflationary. The plasma TV may look more expensive. However, it actually costs less after taking into account all of the improvements in quality, such as the flat screen and actual screen size.

So, let’s return to what is happening to wireless phone plans. In January, the BLS changed its methodology to estimate quality changes for data plans. According to Goldman Sachs analysts, using this new methodology, these new unlimited data plans were 25% cheaper than before. [2] Even though the methodological change occurred at the beginning of the year, its outsized impact occurred in March. That’s when the wireless companies started to offer these new unlimited plans in earnest.

While this seems in the weeds, quality adjustment is a big deal. Quality negatively relates to inflation, but translates into better economic growth and productivity. More importantly, some economists believe that statistical agencies could do a better job of estimating quality change, especially as it relates to creative destruction. Creative destruction is the replacement of old goods or services with new, better ones. Goldman Sachs economists cited new work from economists Philippe Aghion, Antonin Bergeaud, Timo Boppart, Peter J. Klenow, and Huiyu Li. They estimate how the mismeasurement of creative destruction affects U.S. inflation and growth.[3] These researchers found accounting for creative destruction more accurately could add 0.5% to 1% to economic growth per year. That is huge! The methodological change for wireless plans pricing is just one example of that type of statistical improvement. So, move out of the weeds into the forest. Let’s face it, quality adjustment is a big deal!

[1] Here is the actual analysis from BLS: https://www.bls.gov/cpi/cpihqaqanda.htm

[2] The Goldman Sachs report is from Jan Hatzius, Alec Phillips, Spencer Hill, David Mericle, Daan Struyven, Karen Reichgott, and Karen Reichgott, The Return of Missing Growth, April 21, 2017.

[3] The academic paper is “Missing Growth from Creative Destruction,” February 2017.

 

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