CPI bias and stagnation
Feb 5, 2011
3 minute read

Tyler has been defending his stagnation hypothesis with an intuitive argument about when the CPI is most skewed. I’m not 100% persuaded of Tyler’s intuition.

There is a severe conceptual problem that plagues any measure of inflation. It seems easy enough to measure the change in price of a basket of goods, but real-life consumers do not buy the same basket of goods from year to year. Entirely new goods get introduced, and even goods that seem nominally the same tend to improve in quality. These both introduce biases.

Suppose you’re starting with a basket of goods that contains x and y. Then new good z gets introduced. You don’t have the period-ago price of z, so you might continue for a period assuming that consumers are just buying x and y. You add z to the bundle in the following period when you can make a price comparison for z. This is going to cause CPI to overstate inflation, because in the period where z was available on the market but not included in the basket, consumers had greater choice with a given amount of money than the index suggests.

Now suppose you’re starting over, again with a basket of goods that contains x and y. Instead of adding a good z, assume that in some period x and y are replaced on the market by x’ and y’, which are improved versions of x and y. Consumers buy x’ and y’ in roughly the same quantities that they bought x and y, respectively. Since x and y are no longer on the market, there is no price comparison that can be made across periods. One way around this is to assume naïvely that x’ = x and y’ = y. Once again this is going to cause CPI to overstate inflation, because a given amount of money can buy more quality than the index suggests.

Tyler claims that the first problem is more severe in practice than the second. I am not so sure. One reason that we can never be sure is that statisticians at the BLS attempt to correct for both kinds of problems. This is a confounding factor that takes simple intuition out of the picture. How can we know whether net of statistical correction one problem is worse than the other?

But even assuming naïvely that the statistical corrections are equally effective or ineffective, it’s not obvious that the first problem is the most severe. In the periods when truly new goods first get introduced, they typically do not make up a large fraction of the real-world consumption bundle. This is an inherent limit on how much damage they can do to the index. In contrast, secular improvements in goods tend to affect the whole bundle. There is much bigger scope for damage to the index from quality improvements than from the introduction of new goods.

Tyler has been advancing the differential CPI bias argument to amplify, not make, his core argument, but if he has it backwards, that CPI bias has been worse in the post-1973 period than in the pre-1973 period, then his whole stagnation hypothesis crumbles. I’d like to see more discussion of his CPI intuition.

Update: Bryan has more.