The CPI…

The CPI, produced by the Bureau of Labor Statistics of the Labor Department, is the government’s attempt to measure the change in the prices of goods and services paid by urban consumers, who make up 87% of the country’s population.

The CPI is the result of extensive data collection efforts, both from consumers to find out what items they buy and from retail outlets to determine how the prices of those items change.

The CPI is everywhere.  It’s used to determine the annual cost of living adjustment for Social Security, as well as for COLAs in government and private retirement plans.  It’s often used for the same purpose in labor contracts.  It’s also used by the IRS to adjust Federal income tax brackets for inflation and to set threshold levels for public assistance programs like food stamps.

The CPI is now in the spotlight as a bone of contention in the debate over reduction in entitlement benefits, as a way to close the large Federal budget deficit.

…is a Laspeyres index

This means it investigates what consumers buy during a base period (for the current CPI, it’s 2007-08) in order to arrive at a fixed basket of goods and services that it regards as typical. It calculates the total cost of the basket.

From that point on, it periodically checks with retailers to get current prices, using them to update the cost of the original basket.  The ratio of the total cost in today’s dollars of the basket, divided by the cost of the same basket back in 2007-08 is the current CPI value.

What’s wrong with that?

It depends on your perspective, I guess.   But as economists knew, even when the CPI was introduced as the COLA mechanism for Social Security in 1975, the Laspeyres method systematically overstates changes in the cost of living.

That’s because it ignores the fact that consumers constantly change their market basket of goods and services as the prices of items go up and down.  They react to higher prices by switching to less expensive substitutes that they may be perfectly happy with.  The result of this substitution is that the rise in the price of a given item in the original basket doesn’t necessarily mean a rise in consumer expenditure.  But the CPI acts as if it always does.

examples

Suppose, for example, the BLS determines a family buys 10 pounds of chicken meat and 10 pounds of turkey.  Family members don’t really care which they eat.  If the price of chicken doubles and that of turkey remains unchanged, the family will stop buying chicken and buy 20 pounds of turkey instead.  So although the price of chicken has gone up the family’s food expense hasn’t.  Nevertheless, the CPI registers an increase.  The same for hamburger and turkey burger.

Or suppose the price of gasoline goes up and you join a carpool.  Or you buy a Hyundai instead of a Toyota.

Or you get fed up with cable and use Netflix and Hulu instead.

The CPI doesn’t pick up any of this.

a too-high COLA adds up

The Social Security Administration figures that using the current CPI upwardly biases cost of living adjustments by about 0.3 percentage points per year. Put another way, the 1.7% increase in benefits penciled in for 2013 should really only be 1.4%.  The rest is gravy for retirees.

Removing that upward bias from yearly Social Security COLAs would reduce total payments by an estimated $200 billion in the first decade.

the thin edge of the wedge?

Personally, I don’t consider this change in the way the cost of living adjustment for Social Security is calculated to be a big deal.  That’s because the use of the CPI has been the dirty little secret of legislators, Social Security recipients and labor negotiators for decades–although don’t try to tell that to a recipient.

Arguably, if a change to a more accurate cost of living measure for the Social Security COLA helps set the US back on a sounder fiscal footing, the subsequent rise of short-term interest rates to normal levels will benefit anyone with savings, especially seniors.

But once Social Security adopts another measure for COLAs, this sets the stage for replacement of the CPI elsewhere.  So the fight over Social Security may be more acrimonious than this program alone would warrant.