What you need to know about the CPI

By Edwin Dean,
Posted Nov. 25, 2009, at 6:52 p.m.

If you receive Social Security, were you expecting a higher monthly payment next year, to make up for inflation? If so, think again: You won’t be getting one. Government statistics indicate there has been no consumer price inflation in the last 12 months. Instead, prices have fallen by 2 percent.

These government statistics — the Consumer Price Index data — affect many Americans in addition to Social Security recipients. The index also influences payments to people receiving military and federal civil service pensions, food stamps and free school lunches — a total of 80 million people. Further, federal income tax law requires that the CPI be used to adjust income tax brackets and the standard deduction for inflation. And in the private sector, many labor-management contracts, covering millions of workers, specify that cost-of-living wage increases be tied to the CPI.

In fact, through these channels and others the CPI has an impact on virtually all Americans. And because consumer prices have fallen recently, many Americans will not receive adjustments they might be expecting.

Clearly, it’s immensely important to know whether the CPI is accurate.

So let’s take a look at the Bureau of Labor Statistics, the agency that calculates the CPI. Each month, the bureau collects prices from cities and towns in all parts of the country for several thousand consumer items. The CPI staff includes many well-trained and conscientious economists and statisticians. CPI methods are continuously studied by a special bureau research unit — and over the years these studies have yielded major improvements in methods. (Full disclosure: I worked for the Bureau of Labor Statistics for 16 years, though not on the CPI.) Finally, many foreign statisticians give the CPI their highest marks.

Does this mean that the CPI is 100 percent correct? No, it does not, for several reasons.

To begin, consider what happens when a consumer item — say, a particular brand of beer — disappears from store shelves, for whatever reason. That brand is then replaced by a similar brand — though the new brand might actually be of higher or lower quality than the old. If the new item has the same price as the old, but is of lower quality, then the true price actually rose.

To prevent this, a CPI economist must make a judgment about quality change, so the index can be adjusted accordingly. Clearly, human judgment plays a role.

For many items, the bureau tries to measure quality change with mathematical models. But this may not solve the problem completely because data needed for some models may be unavailable. And, once again, human judgment is needed in applying the models to specific goods.

Another problem is that some new information is introduced into the CPI computation process with a fairly long time lag. For example, new survey results on consumer spending patterns, which feed into CPI calculations, are introduced with a lag of two years. Some lags, though, are truly unavoidable.

Medical care prices are especially tough to handle. Academic researchers have argued that for certain medical treatments the CPI overestimates the rate of price increase. But the adoption of these researchers’ recommendations actually might not have much impact on the CPI results.

In my view, no one knows with certainty whether the CPI has exaggerated or underestimated price increases. My crude guess is that it has been correct to within 1 or possibly 2 percent of the true figure.

Some wild and crazy claims have been made about errors in the CPI: One writer argued that the CPI under-estimates inflation by 7 percent a year. A study by John Greenlees and Robert McClelland, two Bureau of Labor Statistics economists, shows that this claim is truly wild. One example of these economists’ reasoning: A 7 percent annual underestimate of inflation implies that average personal income, adjusted for inflation, declined by 40 percent between 1998 and 2008. That is, income declined much more over these 10 years than during the Great Depression of the 1930s.

The bottom line? Though the CPI is certainly not perfect, it rests on a huge, nationwide collection of data and carefully developed statistical methods. The CPI statistics are the best we have, by far, for adjusting Social Security payments for inflation and for many other important private and public uses.

Edwin Dean, an economist and seasonal resident of Vinalhaven, writes monthly about economic issues.

http://bangordailynews.com/2009/11/25/opinion/what-you-need-to-know-about-the-cpi/ printed on July 30, 2014