Inflation Worries? You Can’t Trust the CPI

August 20, 2012

by MARYANN O. KEATING, PH.D.

There is no such thing as a perfect price index. Perfection in price indices requires that the prices of all products increase by the same percentage and that product quality plus the relative amounts of each product category remain constant.  Nevertheless, the Consumer Price Index (CPI), generated by the Bureau of Labor Statistics, is used to adjust retail sales, wages, and gross domestic product for inflation. Inflation is a yearly percentage increase in the overall general price level.  In addition, the CPI is used to adjust Social Security payments, government assistance, and many cost-of-living contracts for millions of American workers.

The best price index is based on personal experience. Recall a few prices for the year in which you purchased your first automobile, earned your first paycheck or got married. Comparing those prices with today’s, you would likely pay more than double for an auto, about twice as much for a burger, and three times as much for a movie ticket. In the absence of a variety of assumptions and mathematical tradeoffs, it is impossible to reduce your personal experience to a single percentage rate of inflation. Using the CPI, however, the Bureau of Labor Statistics valiantly attempts to calculate inflation for the nation as a whole by measuring price changes based on a sample of prices for food, apparel, housing, transportation, medical care, entertainment and other goods and services.

Any index requires a somewhat arbitrary base time period. An index is set at 100 for the base year, and, if prices on average increased 10 percent from the base period, the current index would read 110. The actual CPI currently uses price averages for 1982-1984 as its base year. As of this month (July, 2012), the CPI for all urban consumers (CPI-U) increased 1.7 percent over the last 12 months to an index level of 229.478 (1982-84=100). This suggests that prices have risen on average 130 percent since the early 1980s.

Monthly, field agents around the nation report prices to the Bureau of Labor Statistics from a list containing a fixed market basket of goods and services. The intention is that items in the basket represent constant quality and constant quantity in two different time periods; only prices are assumed to have changed. Obviously, currently available autos, new or used, have air-conditioning, seat belts, air bags, state of the art sound systems and tires good for many more miles than on cars purchased ten or so years ago. The Bureau uses judgment to periodically eliminate from the basket products no longer purchased, as well as to adjust for quality changes and price differences between retail outlets. Field agents are then instructed on the changing characteristics of, for example, half a gallon of whole milk. The Bureau, in addition, rolls in or out different urban areas and retail outlets within its sample.

The Laspeyres’ mathematical formula on which the CPI is based is not particularly suited for adjusting between changes over time in spending categories or for consumer substitution. However, changing percentages of household budgets allocated to food versus transportation, for example, seriously affects the accuracy of the CPI in estimating average rates of change in the general price level. To compensate, the expenditure weights for the 1987 CPI revision relied on the Survey of Consumer Expenditures and the 1980 Census.

Suppose prices on some items go up faster than average. The CPI continues to give the same importance to this group even as consumers shift to lower cost substitutes. The CPI is not attuned to the fact that consumers can maintain their standards of living by wisely substituting lower for higher priced items.

Thus, economists and statisticians acknowledge that the CPI tends to over-estimate inflation. However, repeated studies maintain that this substitution effect is rather small.

The CPI is not a true measure of the cost of living. The cost of living refers to the minimum expenditure required to attain a particular level of satisfaction in two time periods or in two separate locations. Theoretically, the CPI index is identical to the cost of living if consumer preferences do not permit substitution, if goods and services are purchased in the same proportion over time and if prices do not vary between areas of the country.

The impact of inflation differs greatly between households. If your family spends a larger-than-average share of your budget on medical expenses, and medical care costs are increasing more rapidly than other items in the official CPI market basket, your personal rate of inflation may exceed the increase in the CPI. The CPI does not take all household expenditures into account. CPI prices include sales taxes, user fees and licensing charges. No adjustment is made, though, for rising income or payroll taxes — significant components of household income. Also, the CPI does not account for household expenditures on charitable contributions, personal insurance, pensions or investments.

Social Security benefits for more than 60 million Americans increased 3.6 percent in 2012 but there was no increase in 2010 and 2011. The CPI-W, an index based on expenditures by urban wage earners, is the official measure used by the Social Security Administration to calculate cost of living changes (COLAs). Government sets a threshold and observes percentage changes in the CPI before calculating by how much they are required by law to adjust contracts.

The intention here is not to disparage the Bureau of Labor Statistics. There have been many improvements in sampling techniques, data collection, and estimation associated with the Consumer Price Index. The devil you know, namely the CPI, may be better than less-understood formulas for measuring inflation.

Prices can go down as well as up. Therefore, given the recent real estate crisis, it may be best not to reminisce with those whose mortgages are underwater.

Maryann O. Keating, Ph.D., an adjunct scholar of the Indiana Policy Review Foundation living in South Bend, is co-author of Microeconomics for Public Managers, Wiley/Blackwell, 2009.

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