Common Misconceptions about the Consumer Price Index: Questions and Answers
An August 2008 Monthly Labor Review article by BLS economists John
Greenlees and Robert McClelland reviews and analyzes some common
misconceptions about the Consumer Price Index (CPI.) Those analyses
are summarized here:
Has the BLS removed food or energy prices in its official measure of inflation?
No. The BLS publishes thousands of CPI indexes each month, including the headline All Items CPI for
All Urban Consumers (CPI-U) and the CPI-U for All Items Less Food and Energy. The latter series,
widely referred to as the "core" CPI, is closely watched by many economic analysts and
policymakers under the belief that food and energy prices are volatile and are subject
to price shocks that cannot be damped through monetary policy. However, all consumer
goods and services, including food and energy, are represented in the headline CPI.
Most importantly, none of the prominent legislated uses of the CPI excludes food and energy.
Social security and federal retirement benefits are updated each year for inflation by the
All Items CPI for Urban Wage Earners and Clerical Workers (CPI-W). Individual income tax
parameters and Treasury Inflation-Protected Securities (TIPS) returns are based on the All Items CPI-U.
The CPI used to include the value of a house in calculating
inflation and now they use an estimate of what each house would rent for -- doesn't this switch
simply lower the official inflation rate?
No. Until 1983, the CPI measure of homeowner cost was based largely on house prices.
The long-recognized flaw of that approach was that owner-occupied housing combines both
consumption and investment elements, and the CPI is designed to exclude investment items.
The approach now used in the CPI, called rental equivalence, measures the value of
shelter to owner-occupants as the amount they forgo by not renting out their homes.
The rental equivalence approach is grounded in economic theory, receives broad support from
academic economists and each of the prominent panels, and agencies that have reviewed the CPI,
and is the most commonly used method by countries in the Organization for Economic Cooperation
and Development (OECD). Critics often assume that the BLS adopted rental equivalence in order
to lower the measured rate of inflation. It is certainly true that an index based on home prices
would be more volatile, and might move differently from other CPI indexes over any given time
period. However, when it was first introduced, rental equivalence actually increased the
rate of change of the CPI shelter index, and in the long run there is no evidence that the
CPI method yields lower inflation rates than some other alternatives. For example, according
to the National Association of Realtors, between 1983 and 2007 the monthly principal and
interest payment required to purchase a median-priced existing home in the United States
rose by 79 percent, much less than the rental equivalence increase of 140 percent over
that same period.
When the cost of food rises, does the CPI assume that
consumers switch to less desired foods, such as substituting hamburger for steak?
No. In January 1999, the BLS began using a geometric mean formula in the
CPI that reflects the fact that consumers shift their purchases toward
products that have fallen in relative price. Some critics charge that
by reflecting consumer substitution the BLS is subtracting from the CPI
a certain amount of inflation that consumers can "live with" by
reducing their standard of living. This is incorrect: the CPI's
objective is to calculate the change in the amount consumers need
to spend to maintain a constant level of satisfaction.
Specifically, in constructing the "headline" CPI-U and CPI-W, the BLS is not
assuming that consumers substitute hamburgers for steak. Substitution is only
assumed to occur within basic CPI index categories, such as among types of ground
beef in Chicago. Hamburger and steak are in different CPI item categories, so
no substitution between them is built into the CPI-U or CPI-W.
Furthermore, the CPI doesn't implicitly assume that consumers always substitute
toward the less desirable good. Within the beef steaks item category, for
example, the assumption is that consumers on average would move up from
flank steak to filet mignon if the price of flank steak rose by a greater
amount (or fell by less) than filet mignon prices. If both types of beef
steak rose in price by the same amount, the geometric mean would assume no substitution.
In using the geometric mean the BLS is following a recognized best practice for
statistical agencies. The formula is widely used by statistical agencies around
the world and is recommended by, for example, the International Monetary Fund
and the Statistical Office of the European Communities.
Is the use of "hedonic quality adjustment"
in the CPI simply a way of lowering the inflation rate?
No. The International Labour Office refers to the hedonic approach as
"powerful, objective and scientific". Hedonic modeling is just one of
many methods that the BLS uses to determine what portion of a price
difference is viewed by consumers as reflecting quality differences.
It refers to a statistical procedure in which the market valuation
of a feature is estimated by comparing the prices of items with
and without that feature. Then, for example, if a television in
the CPI is replaced by one with a larger screen and higher price,
the BLS can make an adjustment to the price difference by
estimating what the old television would have cost had it had
the larger screen size.
Many of the challenges in producing a CPI arise because the number
and types of goods and services found in the market are constantly
changing. If the CPI tried to maintain a fixed sample of products,
that sample quickly would shrink and become unrepresentative of what
consumers were purchasing. Each time that an item in the CPI sample
permanently disappears from the shelves, the BLS has to choose
another, and then has to make some determination about the
relative qualities of the old and replacement item. If it did
not--for example, if it treated all new items as identical to
those they replaced -- significant upward or downward CPI biases would result.
Critics often incorrectly assume that BLS only adjusts for quality
increases, not for decreases, and that hedonic adjustments have a
large downward impact on the CPI. On the contrary, BLS has used
hedonic models in the CPI shelter and apparel components for roughly
two decades, and on average hedonic adjustments usually increase the
rate of change of those indexes. Since 1998, hedonic models have been
introduced in several other components, mostly consumer durables such
as personal computers and televisions, but these newer areas have a
combined weight of only about one percent in the CPI.
article by BLS economists estimated that the hedonic models currently
used in the CPI outside of the shelter and apparel areas have
increased the annual rate of change of the All Items CPI, but by only
about 0.005 percent per year.
Has the BLS selected the methodological
changes to the CPI over the last 30 years with the intent of lowering the reported rate of inflation?
No. The improvements chosen by the BLS that some critics construe to
be a response to short term political pressure were, in fact, the result
of analysis and recommendations made over a period of decades, and those
changes are consistent with international standards for statistics. The
methods continue to be reviewed by outside commissions and advisory
panels, and they are widely used by statistical agencies of other nations.
Moreover, the sizes and effects of the changes implemented by the BLS are often
over-estimated by critics. Some have argued that if the CPI were computed
using the methods in place in the late 1970s, the index would now be growing
at a rates as high as 11 or 12 percent per year. Those estimates are based on
the belief that the use of a geometric mean index lowered the annual rate of
change of the CPI by three percentage points per year, and a belief that other
BLS changes, such as the use of hedonic models and rental equivalence, have
lowered the growth rate of the CPI by four percentage points per year.
Neither belief is supported by evidence. BLS calculations have shown that the
geometric mean formula has reduced the annual growth rate of the CPI by less
than 0.3 percentage points. Hedonic quality adjustments for shelter regularly
increase the rate of change of the CPI, and those for apparel have had both
upward and downward impacts at different points in time and for different
types of clothing. The BLS estimates that the overall impact of hedonic
quality adjustments in use in other categories has been extremely small.
Furthermore, if the CPI were using the pre-1983 asset-based method instead of
rental equivalence to measure homeowner shelter cost it would yield a sharply
lower current measure of shelter inflation, given that house prices are now
declining in many parts of the country.
Does the Bureau of Labor Statistics
calculate the CPI the same way as other nations? Do any differences in method keep the US CPI lower than the CPIs of those other nations?
Yes, the methods described above are used widely by nations in the
OECD and the European Union. A recent report shows that rental
equivalence is the most common method used to measure changes in the
cost of shelter by the OECD -- with 13 of 30 nations employing it. The
next most common method is for a nation to omit shelter from the CPI.
The hedonic method of quality adjustment is used by at least 11 of the
29 other OECD nations, and five of the G-7 nations. Eurostat reports
that the geometric mean is used by 20 of 30 countries for its Harmonized
Indices of Consumer Prices.
Each nation's inflation experience is the result of its unique economic
circumstances, so comparing the change in the U.S. CPI-U with inflation
rates in other countries does not gauge the accuracy of U.S. inflation
measures. Nevertheless, over the 1997-2007 period the U.S. CPI-U
increased faster than the CPIs of 16 of the other 29 OECD nations, and
faster than the CPIs of all of the other G-7 nations, including Canada,
the United States' largest trading partner. Similarly, between the first
quarters of 2007 and 2008 the U.S. CPI rose by more than the CPIs of 20
of the other 29 OECD nations and by more than any of the other G-7
nations, including Canada.
Last Modified Date: September 5, 2008