Short Run Recommendations3

Recommendation i.

The BLS should establish a cost of living index (COLI) as its objective in measuring consumer prices.

The advisory commission’s report begins with one overarching recommendation: "The BLS should establish a cost of living index (COLI) as its objective in measuring consumer prices." The BLS basically concurs with this; indeed, the BLS long has said that it operates within a cost-of-living framework in producing the CPI. That framework has guided, and will continue to guide, operational decisions about the construction of the index.4  Putting things slightly differently, if the BLS staff or other technical experts knew how to produce a true cost-of-living index on a monthly production schedule, that would be what we would produce. While the BLS broadly agrees with the commission that the objective of our CPI program ought to be to produce a cost-of-living index, it is important to note that there are many different cost-of-living indexes that could be taken as the CPI’s target. The cost-of-living index approximated by the CPI answers the following question: "What is the minimum change in expenditure that would be required in order to leave the average consumer unit indifferent (or as well off) between a specified reference period’s prices and a comparison period’s prices?"5  Consumers’ well-being depends on many aspects of life other than market goods and services, e.g., environmental quality and amenities (such as clean air and low crime), goods provided through taxes (such as national defense and fire protection), health status, and future consumption goals (which depend on both current and expected future income, and savings). The BLS defines the scope of the CPI, however, to include only market goods and services or government-provided goods for which explicit user charges are assessed. The cost-of-living index approximated by the CPI is, therefore, a subindex of the all-encompassing cost-of-living concept, specifically a subindex that is conditional on the excluded factors that affect consumer well being, such as health status and the quantity and quality of government-provided goods and services.6

Because the cost-of-living concept does not imply a single all-purpose cost-of-living index, the BLS will continue to need to make choices about the specific issues of formula, coverage, and index construction. One criterion in making these choices is the need to employ methods that are appropriate for a statistical agency. Those methods must be rigorous and objective rather than speculative, minimizing the role of arbitrary BLS judgments.7  We recognize, for example, that changes in disease incidence or public safety levels affect consumer well-being in ways that are difficult or even impossible to quantify using methods that meet these standards. We also believe, however, that adhering to the standards is critical to maintaining the credibility of our official statistics. An important part of the BLS’ responsibility, therefore, is to describe for data users the scope and theoretical assumptions of its price measures, as well as any necessary caveats with respect to their use.

In summary, the BLS has no fundamental disagreement with the commission about what the objective of the CPI should be, though we would emphasize that it is important to be clear about what precisely one means by a cost-of-living index. We will continue to exercise our judgment on the appropriateness of taking any specific step designed to bring the CPI closer to a true cost-of-living index, bearing in mind that it is crucial that any official statistic be based on rigorous, objective methods.

Recommendation ii.

The BLS should develop and publish two indexes: one published monthly and one published and updated annually and revised historically.

Recommendation iii.

The timely, monthly index should continue to be called the CPI and should move toward a COLI concept by adopting a "superlative" index formula to account for changing market baskets, abandoning the pretense of sustaining the fixed-weight Laspeyres formula.

Recommendation iv.

The new annual COL index would use a compatible "superlative-index" formula and reflect subsequent data, updated weights, and the introduction of new goods (with their history extended backward).

Because these three recommendations address methods for dealing with the upper-level substitution bias problem, we will discuss them together.

Some index formulas, known as "superlative" indexes, have been shown theoretically to be closer to the cost-of-living concept than measures like the CPI that track the cost of a fixed basket.8  The major superlative indexes are the Fisher and Törnqvist measures. Using these formulas, one can construct an index that accounts for the changes that consumers make in the quantities of the goods and services they consume in response to changes in relative prices. By substituting goods that have become relatively cheaper for those that have become relatively more expensive, consumers can achieve the same standard of well-being for less than the cost of purchasing their original market basket. Because the CPI holds the market basket fixed at base period quantities, it incurs substitution bias by putting too much weight on the relatively more expensive items from which consumers have shifted away. The superlative indexes, because they adjust for changes in consumer expenditures, tend to avoid this type of bias. The superlative indexes do, however, require information on the current period market basket. Because it takes time to collect and process consumer expenditure data, a superlative index can be produced only with a time lag.9

The commission recommends that the BLS should move to a "trailing Törnqvist" formula for the monthly index.10 By this they mean a geometric mean formula in which the weights are lagged expenditure shares and are updated each year. The resulting measure would not be a true superlative index, although it would be intended to provide a feasible real-time approximation to a Fisher Ideal or Törnqvist index. The commission also recommends that the BLS develop a new annual index that is calculated using a true superlative formula and is subject to revision.

The BLS continues to investigate several experimental indexes that are designed to address consumer substitution across item categories. These include superlative formulas which, due to the need for current expenditure data, create indexes that must be produced with a lag, as well as new methods that may approximate the superlative formula and allow the production of indexes in a more timely fashion.

The timeliness of the CPI might be maintained by using some form of an approximation to a superlative index. The commission’s proposed "trailing Tornqvist" formula, however, has been shown to produce price changes that systematically understate the increases in the cost of living, as measured by the superlative formulas.11 More recently, other approximation strategies have been proposed, including a method based on the "constant elasticity of substitution" (CES) formula.12 But such an approximation would not track the superlative indexes precisely—during some years an index based on an approximation would rise more than the superlative index, during other years it would rise less. This feature raises the issue of whether such an index subsequently would need to be revised once the data were available to calculate the superlative index. Another issue that needs to be addressed in considering use of approximations is the issue of estimating the subaggregate indexes, i.e., the indexes for intermediate levels of aggregation, such as for "food" or "transportation." Some of these indexes may consist of item categories that are relatively close substitutes—fresh fruits, for example, consists of apples, bananas, oranges, and other fruits—whereas others may consist of item categories that probably are not close substitutes—medical professional services, for example, includes physicians, dentists, and eye care. Because the CES function is based on a single elasticity parameter which is assumed to be the same for all items, while consumers’ willingness to substitute is likely to vary across categories of items, further research is needed to determine whether a simple approximation such as the CES would produce sensible approximations for all of these subaggregates. Also, the use of an index based on statistical approximation might be difficult to interpret and explain to users of the data. We believe we would gain little, and possibly do much damage to the credibility of our statistical system, if we were to move hastily to adopt untested techniques for producing the official CPI.

The BLS has requested funds to improve the accuracy and timeliness of the CPI, and an important part of this request will support the production of a superlative index, produced to a greater degree of accuracy than is now possible. The BLS plans to begin publishing this measure in 2002. Selection of a specific form for the index requires that several design issues be resolved. Most fundamental will be the choice between production of an annual index with a lag and production of a monthly or quarterly index that is subject to revision as new annual expenditure data became available. The BLS also will have to address more technical issues such as functional form, estimation of expenditure weights, and whether substitution across areas will be treated in the same way as substitution across item categories. In the interim, the superlative measures we currently produce can be used to estimate the magnitude of the upper level substitution bias in the CPI, and indeed are the best measures currently available for this purpose.

Another key aspect of these commission recommendations is the annual updating of expenditure weights. Historically, the CPI expenditure weights have been updated at roughly ten-year intervals, corresponding to the availability of decennial Census population data and (prior to the 1980s) of Consumer Expenditure Survey (CEX) data. Most recently, in January 1998 the CPI was updated using the 1990 Census and 1993-95 spending patterns. The BLS has indicated, however, that future updates will take place more frequently. A decision concerning the appropriate interval between weight updates will be made soon, based on additional study both of the importance of employing current spending weights and of the "chain drift" distortions that potentially could result from too-frequent weight changes. In this regard, the BLS has requested funds for an enhanced CEX sample size and for computer system enhancements that will permit the introduction of more current spending data whenever the weights are updated.

The BLS also is evaluating the production of a historical research series that would be revised as new methodological improvements are developed and implemented in the official index. Such an index could be of value to research economists and others concerned with past movements in prices, income, productivity, and other economic variables.

In summary, the BLS does not accept the specifics of these recommendations but has initiatives underway to address upper-level substitution bias and the currency of the CPI market basket. Further research is needed to determine whether the experimental techniques under investigation for producing the official monthly CPI would yield a more accurate measure. We believe that hasty implementation of such techniques without more complete testing would damage the credibility of our statistical system. The BLS has requested funds to support publication of a superlative index as a complement to the CPI beginning in 2002. Additionally, the BLS has requested funds to expand the Consumer Expenditure Survey sample size and develop enhanced computer systems to support the timely introduction of more current spending data when the index weights are next updated. Finally, the BLS will announce a decision to make more frequent updates to expenditure weights in the near future.

Recommendation v.

The BLS should change its procedure for combining price quotations by moving to geometric means at the elementary aggregates level.

To address lower-level substitution bias, the commission suggested the adoption of a geometric mean formula for aggregating price quotations, a formula that has been under investigation by the BLS over the past several years. On April 17, 1998 the BLS announced that the geometric mean formula will be used in the CPI in place of the current Laspeyres formula in all item strata except for selected shelter services, selected utilities and government charges and selected medical services.13   This change will be implemented with the CPI release for January 1999. Our best estimate is that the planned use of the geometric mean formula will lower the growth rate of the CPI by approximately 0.2 percentage point per year. A discussion of the decision and the rationale for the adoption of the geometric mean formula is presented in the paper entitled "Planned Change in the Consumer Price Index Formula" which is appended to this document.

Additional recommendation regarding expanded use of hedonic regressions for making quality adjustments.

The advisory commission report did not contain an explicit recommendation concerning the use of hedonic regressions, but the commission members later emphasized their support for increased use of this approach to quality adjustment.14   This is, in fact, a critical element of BLS current practice and future plans. For several years, hedonic quality adjustments have been used in the CPI apparel and rent indexes. Starting in January 1998, the hedonic model developed and used in the Producer Price Index for adjusting computer prices has been employed in the Personal Computers and Peripheral Equipment category of the CPI. New hedonic research is underway on video and audio equipment data. Most importantly, funds have been requested to support ongoing collection of product price and characteristic data, focused on consumer durable items. It is expected that this information will enable the BLS to expand significantly the use of hedonic quality adjustment methods in future years.

In summary, the BLS agrees with the commission that the use of hedonic regression techniques in quality adjustment should be expanded. The BLS has used hedonic quality adjustment for selected CPI components for several years, has recently extended its use to additional components, and has requested funds for continued expansion.

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Last Modified Date: October 16, 2001