Volume 3,
No.3
Fall 1997
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Articles:
A CPI Primer,
or Why the Fuss Over the Consumer Price Index?
Throughout
Southern Illinois: Mines Move Out As Prisons Move
A CPI PRIMER, OR WHY THE FUSS OVER THE CONSUMER
PRICE INDEX?
By: Richard Kaye
Recently, the media has been saturated with pieces of the Consumer Price Index, each making a case for whether or not the CPI overstates inflation and to what extent. Maybe you've wondered: Why all the fuss? This article explores what the CPI is and is not, its uses and limitations, what has been proposed to correct shortcomings, and the potential, far-reaching impact of the proposed changes on everything from social programs to monetary policy.
CPI:
What It Is
The CPI, which originated in
1919, is simply a measure of the average change over time in the prices
paid for a fixed market basket of consumer goods and services. Here's
how it works: About every 10 years, the Bureau of Labor Statistics (BLS)
surveys the buying habits of American families to determine which items
go into the market basket. The survey covers products purchased in stores
as well as larger expenditures, like housing. Participants surveyed during
the current base period: 1982, 1983, and 1984 provided detailed records
of actual purchases (called the Consumer Expenditure Survey). Some families
kept diaries of everything they bought during a 2 week period. All goods
and services with prices that can be determined every month are listed
by BLS and estimates are made of the quantities of each item bought by
the average family. The average index level, representing the average
price level, was set at 100 for the 1982-84 reference base. This allows
for comparison of changes in the index from the reference base period
to a later year; the rate of increase of decrease is expressed as a percent.
For example, in 1991 the national index average was 136.2; this represents
a 36.2 percent across the board increase in the cost of the market basket
of goods and services from the 1982-84 base period. At 177.0 in 1991,
medical prices (a component of the index),rose faster than average: +77
percent from 1982-84 while energy costs, at 102.5 in 1991, were up by
only 2.5 percent. Item costs are based on actual prices, including sale
prices, recorded by BLS staff during monthly visits to stores. BLS surveyors
are especially careful about new car prices because 1) they represent
a big chunk of the index, and 2) few new car buyers pay the sticker price.
Based on these detailed prices, each month BLS computes the new level
of the index. Reference base periods are updated about every 10 years.
Two Population Groups Represented
Two indexes are published:
(1) The CPI-U measures the cost of living for urban consumers; this is
the most commonly referenced number and covers approximately 80 percent
of the total population, and
(2) The CPI-W for urban wage earners and clerical workers, covering approximately
32 percent of the total population.
Persons living outside urban
areas, farm families, persons in the Armed Forces, and those in institutions
(such as prisons and mental hospitals) are not included in the index.
| "The
best measure of inflation for a given application depends on the intended
use of the data. The CPI is generally the best measure for adjusting
payments to consumers when the intent is to allow them to purchase,
at today's prices, the same market basket of consumer goods and services
that they could purchase in an earlier reference period. It is also
the best measure to use to translate retail sales and hourly or weekly
earnings into real or inflation-free dollars." --From: Understanding the Consumer Price Index:Answers to Some Questions US Department of Labor/ Bureau of Labor Statistics, July 1996 (Revised) |
In addition to the national index, the CPI is also computed for regions and cities. The market basket of goods and services is very clearly defined, classifying over 200 categories into seven major groups (see the chart on page 7). Information is collected by the Bureau of the Census for the Bureau of Labor Statistics and includes eighty-five census areas and approximately 90,000 items; data are contributed by 21,000 establishments across the country. Price changes from the previous month for the various items in each location are averaged together and weighted by their importance to the spending of the population group. Local data are combined to obtain city averages, with separate indexes published by size of city, region of the country, and other formats. For some metropolitan areas, data are published every other month or every six months. Monthly indexes are published for the nation, and for the following five major metropolitan areas:
- Chicago-Gary-Lake County, IL-IN-WI
- Los Angeles-Anaheim-Riverside, CA
- New York-Northern NJ-Long Island, NY-NJ-CT
- Philadelphia-Wilmington-Trenton, PA-NJ-DE-MD
- San Francisco-Oakland-San Jose, CA
In this article we will look
at the national CPI.
What
It Is Not
As important as what the CPI is, is what it is not;
and herein lies the primary reason for the current controversy about the
index and why some economists allege that the CPI overstates inflation.
The CPI is an index of price changes only and does not reflect changes
in buying or consumption patterns. It does not reflect changes in spending
patterns over time. Since it is not affected by changes in consumer buying
habits, the CPI makes it easy to compare the costs of the same market
basket items from month to month or year to year. In addition, the CPI
does not measure individual price change experiences but only the situation
of the average. For example, if I live in the Chicago-Gary-Lake County,
IL-IN-WI area and spend less than the market basket average on housing
for my area, my personal experience with price change will be less than
that indicated by the CPI. This experience is also impacted by the "every-ten-year"
changes in the items included as well as the weighting of the individual
components. So, if I spend less than average on housing and housing has
become a larger portion of the index, my personal price change experience
will be overstated by the CPI.
|
Because of the many uses of the CPI, most Americans are affected by it. Even though it is an index of price change only, it continues to be used as a low cost of living proxy, primarily in three areas:
|
Issues
limiting the CPI
Four areas of technical concern remain with the CPI, particularly since
it continues to be used as a proxy cost of living index:
1) The substitution effect does not allow for the substitution
of a cheaper product for a more expensive product in the fixed market
basket when relative prices change.
2) The sample rotation effect arises because the current procedures
for introducing new items and outlets tends to give disproportionate weight
to changes made if, in the month of introduction, they are temporarily
high or low.
3) Outlet substitution, similar to the substitution effect above
arises when consumers substitute a less expensive outlet if they do not
factor in the lower level of customer service provided by such stores.
4) Lastly, the quality-adjustment bias, considered by many to be
the most serious shortcoming, arises simply as improvements in the quality
of the goods and services unreflected in price.
The timeliness of an every-decade revision of the market basket composition
is also an issue of concern.
Remedies
The current media spotlight on the CPI results primarily from the Boskin
Commission, a Presidential Commission charged with determining what, if
any, bias existed in the CPI. Commission members, primarily academics,
rendered the option (not unanimous) that primarily due to the quality
and substitution issues present in the current CPI, there was an overstatement
of 1.1 percent annually. Although a fairly consistent agreement as to
the presence of an upward bias exists among most concerned parties, the
extent of the bias and the requisite corrective action are topics of widespread
disagreement. The Boskin Commission estimated a 1.1 percent annual excess
and other economists have estimated component effects varying from a 2.3
percent overstatement in the telecommunications portion (by not including
cellular phones) to a $.27 average per person improvement in the overall
welfare of the American public by General Mills 1989 introduction of Apple
Cinnamon Cheerios!
The above disagreements could be said to highlight the renowned inability of economists to agree on much of anything and their dependence upon assumptions which, in many cases, bear little resemblance to reality. Two mainstream suggestions, however, have been suggested for corrective action:
- Assemble a blue-ribbon panel of a cross-section of knowledgeable and concerned parties to determine on an annual basis the overstatement of the CPI and to take corrective action. The most prominent advocate of this approach is Federal Reserve Chairman Greenspan.
- The BLS has developed a computational methodology called the experimental CPI using geometric means which proposes to compensate for the current method's inability to reflect consumers' changes in spending patterns as relative prices change. The experimental method (referred to as CPI-U-XG as contrasted to the currently used CPI-U and CPI-W) basically utilizes a geometric instead of an arithmetic mean in the early stages of producing the final index. In the period from December 1990 to February 1997, the CPI-U-XG rose 16.2 percent compared to 19/3 percent for the arithmetic method. This translates into an annual average disparity of 0.34 percent, mostly in food and beverages, apparel and upkeep, medical care, and entertainment.
Impact of CPI Changes
If you couple the disagreement among economists with the fact that any action (including no action) has political implications, any final resolution is not on the near horizon. Extensive further study is certain. This is, perhaps, for the best since the implications of any corrective action are enormous. Referring to the earlier discussion of uses of the CPI, adjusting dollar values would affect most government transfer payments (i.e. Social Security) as well as many other social programs. It would also impact COLA (cost of living adjustment) in labor bargaining agreements. These in turn would affect fiscal policy, particularly taxes. The CPI's use as an economic indicator would also affect monetary policy. It has been estimated, for instance (by some of the same economists who widely disagree), that the Boskin Commission's 1.1 percent overage, if compensated for, would singly solve the federal government's deficit. Politics aside, caution and certainty are required in this process.
How to Get CPI Information
BLS makes CPI information
available in several formats: Illinoisans can call the Chicago CPI hotline:
(312)353-1883 or BLS Fax-on-Demand: (312)987-9288
More CPI information, including publications:
Local and regional - Region V
Bureau of Labor Statistics
5th floor, Federal Office Building
230 S. Dearborn Street
Chicago, IL 60604-1595
Phone: (312)353-1880
Recorded CPI information: (312)353-1883
National:
For 24-Hour Recorded CPI data (press 1 for recorded messages; a menu follows
and you have the option of speaking to a technical representative), free
summary data CPI-U and CPI-W, and other reports (some requiring fees):
Office of Publications and Special Studies
Bureau of Labor Statistics
2 Massachusetts Avenue, NE, Room 2850
Washington, DC 20212-0001
Phone: (202)606-7828
For our readers who have access to the Internet, CPI information can currently
be found at the following addresses:
http://stats.bls.gov/ro5home.htm
For CPI tables:
http://stats.bls.gov/news.release/cpi.toc.htm