Official CPI: Does it accurately reflect inflation?

CPI(Consumer Price Index)

"The Consumer Price Index (CPI) is a measure of the average change over time in the prices of goods and services that people buy. The CPI is a complex construct that combines economic theory with sampling and other statistical techniques and uses data from several surveys to produce a timely and precise measure of average price change for the consumption sector of the American economy .  The CPI measures the change in the retail prices of approximately 80,000 specific goods and services, called the market basket. The goods and services fall into eight major categories: food and beverage, housing, apparel, transportation, medical care, recreation, education and communication, and other."

The CPI started being measured in 1919 but really caught on after WWII.  For most of that time the BLS used a formula called the Laspeyres formula which measures the change in the cost of a fixed market basket of goods and services. 

CPI is used as a basis for almost everything.  It is the most widely used measure of inflation used to formulate monetary and economic policy.  CPI is also used by business leaders and private citizens as a guide in making economic decisions. 

"Social
Security
benefits and military and Federal Civil Service pension payments are all indexed by the CPI. The Food Stamp program uses the CPI for food at home, and changes in the CPI affect the cost of school lunches for children. In the private sector, many collective bargaining agreements tie automatic wage increases to the CPI. Some private firms and individuals use the index to keep rents, alimony, and child support payments in line with changing prices."

Definition of the Laspeyres Formula
"In this formula the quantities of the goods and services purchased by urban consumers during a base period serve as the weights for the prices, so that the value of the market basket represents the cost of purchasing the same items as were purchased during the base period. The CPI measures the current cost of the market basket relative to its cost during a reference period. In other words, the Laspeyres price index answers the question: What is the value of the base-period market basket in today's prices?"

That formula worked great for everyone until the Mid 90's, when the national debt started skyrocketing and the impending retirement of the Baby Boomers started making policy makers wonder how we would fund these expenses.

Here is where the important changes started that compromised the CPI as an accurate measure of Inflation.

"In December 1996, the Advisory Commission to Study the Consumer Price Index, commonly known as the Boskin Commission, recommended the use of the geometric mean formula for the aggregation of prices within all item categories in the CPI. This recommendation was based upon the belief that a geometric mean formula would help to correct what the Commission called substitution bias.  The commission, using empirical evidence and the members' own judgments about the magnitude of these biases, concludes that the CPI overstates the true cost-of-living change by 1.1 percentage points per year. " 

That last statement shows how the members of the commission want the CPI to reflect a "cost-of-living" change which is variable based on which generalized ideal behavior pattern the BLS expects everyone to follow.

The BLS's reasoning for changing the calculation method follows:

 "Thus the index did not reflect the fact that consumers can and do, to some degree, insulate themselves from the impact of higher prices by adjusting their spending to favor relatively lower-priced goods or services. Consequently, the old version of the CPI(using the Laspeyres Formula), when compared with a measure that reflects this substitution effect, tends to overstate the rate of price increase consumers experience. "  I admit that sometimes people will substitute one item for another based on price but not everyone substitutes say ground beef for steak if steak is too expensive.  And not everyone substitutes every time they shop. 

In their reasoning we again see their desire to use a generalized ideal behavior pattern, instead of a measure of the actual price changes of goods and services over time, for computing CPI.  In 1999, when these new formulas started being used,  the CPI's usefulness as a gauge of real price inflation was over. 

Another insidious feature of the "geometric modelling" formula is how it weights goods that are rising or falling in price.  The geometric formula automatically allocates less weight in the "market basket" to goods rising in price and more weight to goods falling in price.  For example, if beef is rising in price and chicken is falling the formula assumes we buy more chicken and less beef.  This is what I call generalizing an ideal behavior pattern.  Undoubtedly, while doing their surveys the BLS comes across a percentage of consumers who do regularly change their normal shopping habits based on price everytime the shop but it just seems incredulous to assume that's how everyone behaves.

Another method the BLS started using in the 90's and expanded greatly in 99 is Hedonic Modelling.  Here's their definition of how they use the formula for TV's.
 "when a television model in the CPI sample improves in some way, the value of that change, as derived from the Hedonic regression estimates, will be deducted from the observed price change for that product. "

Nearly all new product prices are added to the CPI this way including Computers, Clothing/Apparel, Appliances, New Automobiles, and Furniture.  For example, let's say 5 years ago you bought a refrigerator that costed $1K.  Today you go out and buy a new Refrigerator that costs $1500.  The economists at the BLS look at the how the new Refrigerator has an ice crusher and is more energy efficient than the old one so they deduct $350 off the price and say the New Refrigerator costs only $1150. even though you just paid $1500. for it.  Do you think that kind of assumption is crazy?  How could the CPI accurately measure inflation with Economists changing actual prices, based on some "value" assumptions no one could ever quantify,  before adding them to the results.

The CPI was meant to be a tool to measure real inflation according to real price changes.  Calculating the CPI based on what economists at BLS think people will do in response to higher prices or how those same economists change real prices on new products before adding them to the CPI gives us a measure of a generalized ideal behavior pattern rather than actual price reality .  If the BLS wants to create a separate CPI to measure those "personal choice and benefit" factors that's great, but the CPI used to calculate policy and inflation and payments should measure the change in price on a fixed basket of goods compared to a fixed reference period, like it used to be calculated.  How else can you accurately measure how much more or less something costs today than a year ago?

Now that you've made it this far you're wondering why all this is so important.  It's better for the government in the long run to massage the CPI down so we won't go bankrupt, right?  After all, with every Government payment and union wage tied to the CPI, manipulating that number is an easy way to not have to make hard choices about entitlement programs and still slow the rate of growth in those programs. 

But, like most things in our government these days, the easy solutions only makes the problems worse.  Intentionally distorting the CPI to reduce Federal Deficits allows irresponsible spending and unsustainable policy to continue.  What the Boskin Commission should have stated is that the CPI measure is as good as it always was and the government should modify it's spending priorities based on the higher real inflation that the CPI was then showing.  And in 1999, instead of further diminishing the usefullness of the CPI in predicting real inflation, the BLS again could have told Congress to alter their spending patterns and entitlement programs because of higher real inflation. 

I applaud the BLS for their openness and honesty about how and why they changed their calculation of the CPI.  They were probably under intense political pressure to do so.  But now that we can look back and see the flaws in the current calculation and how it severely understates real inflation, we need to return to the original method of calculating the CPI.  We already would have been reforming our programs and spending patterns for 8 years now if the BLS wouldn't have changed the formula in 99. 

But , there is still time now for reform as well.  But we need to act soon before it's too late.  We need to return to the original real price inflation calculation method of measuring the CPI.  Currently, it is still calculated by a few sources and is at 7% now compared to the Official CPI which is at 3.5%.  Basing payments on the real inflation number would force Congress to reform the entitlement programs and spending priorities to account for this higher inflation.  Social Security will run a $280 Billion surplus this year with surplusses extending out until 2017.(I'll discuss Entitlement Program trust funds in a future article).  By saving that money every year for the next ten years in a global index fund instead of spending it, and writing IOU's to ourselves, and reforming other programs in similiar ways, and implementing spending cuts to offset the savings, we could honestly acknowledge and plan for higher inflation while actually restoring integrity to the Federal Budgeting process. 

Rob.


All of the infromation given here came from the Bureau of Labor Statistics website.

 

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