Dan Spillane: Con Job Finger-Pointing

(SEATTLE) 10/13/04 -- Bill Gross’s " Haute Con Job” (Pimco, October 2004) drew quick criticism from Bloomberg’s John Berry and the Fed’s William Poole, according to the latest exchange in Gross’s rebuttal.

Yet, the main—and very financially relevant--point of Bill’s original story seems to have evaded both Berry and Poole. That being, over the long term, an increasing number of hedonic and other adjustments and non-adjustments (such as rent equivalence) have come to change--and in many cases lower--major headline inflation indices since the 1980s. However, during the same period, there is absolutely no evidence that government programs and financial instruments keyed on these inflation indices have factored such changes in. Thus, in practical terms, inflation expectations and fiscal actions related to inflation reports have been based on indices assuming constant measures—but instead, the measures have drifted. In scientific circles, this is heresy--imagine the consequences of changing the definition of a mile or kilometer. Suddenly, cars might be more (or less) fuel-efficient based on a government edict!

So all the talk about “inflation in the 1970s” related to present figures is based largely on non-comparable headline numbers. And in fact, more recently, and to some unknown extent each year, changes in inflation-measuring indices have lead to an unidentified gap between the actual cost of things, and reality. So Gross is right on track.

And speaking of reality, you have to question the application of hedonic measures in practical contexts. Take for example, the measures for personal computers (and as a side note-- Berry’s analysis correctly states the CPI computer weighting is small, but neglects to mention the high negative magnitude). In the case if computers, it is assumed that we are always getting “more bang for the buck” in terms of hardware. Yet, as everyone knows, computer hardware is fully dependent on software. And, as it turns out, new versions of computer software often require more hardware--which largely negates the hedonic price decay used in US CPI calculations. Therefore, if we assume we live in a globally competitive economy, in order to retain a level of relative productivity growth, it is correct to assume the amount spent on computers will not fall by nearly as much as reported in the CPI, if at all. In fact, as the number of software applications grows to cover more tasks, it is likely a more expensive computer will be not only desired, but be needed to handle new tasks. In other words, the notion of hedonics and price decay is a sham—or con job. Indeed, over time, and combined with other factors in the CPI, this heist has slowly and quietly slipped in to the US bond market and social entitlement programs. That is, very much like a thief in the night—who, being unnoticed, keeps coming back for more. Unnoticed…or willfully ignored, by Berry and Poole, as the case might be.

ENDS

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