7.11: Limitations

Although the CPI is one of the most closely watched economic indicators, it is not perfect. Its shortcomings have caused some analysts to look elsewhere for their inflation data. One of these less-than-satisfied analysts may be the Chair of the Federal Reserve. It is rumored that the lead policymaker at the Fed prefers the personal consumption expenditure index as his inflation indicator of choice.

Now, before you stop reading and turn off your computer, I want to say that even with the issues we are about to discuss, the CPI has a lot to offer and is still a vital economic indicator.

The three major concerns regarding the CPI are:

• volatility
• quality changes
• substitution bias

Volatility

Some of the items and categories tracked in the CPI fluctuate in price more than others, on a month-to-month basis. If the fluctuations are large enough, they can have a disproportionate effect on the overall index level, given the item's relative importance within the index. These effects can mask inflation's true underlying trend.

Food and Energy Components

Along with its CPI-U report, the BLS publishes the CPI excluding food and energy, called the Core CPI. The Core CPI is a subset of the CPI-U and represents the bureau's attempt to identify the underlying trend in CPI inflation by excluding certain components subject to large relative price changes. The reasoning is that unusual changes, such as the 12.9 percent decrease in energy prices from March 2001 to March 2002, or the 4 percent one-month jump in tobacco prices in February 2002, are unlikely to be related to the underlying trend in CPI inflation. The Core CPI systematically removes from the overall inflation calculations a limited set of components (food and energy) thought to be subject to large, temporary price changes often related to supply disturbances.

Figure 8

It is often difficult to tell from raw, unadjusted statistics whether developments between any two months reflect changing economic conditions or only normal seasonal patterns. Therefore, many economic series, including the CPI, are seasonally adjusted to remove the effect of seasonal influences. Seasonal influences are those that occur at the same time and about the same magnitude every year. They include price movements resulting from changing climatic conditions, production cycles, model changeovers, and holidays.

If there is a failure to make adequate adjustment for changes in the quality of the goods and services people buy, a misrepresentation of inflation can occur.

When there are changes in an item's characteristics or significant changes in its price, an analyst from the BLS determines if a quality change has occurred. But this can be a very subjective and difficult task. For example, suppose cable TV services have been expanded to include two additional educational channels and seven additional entertainment channels, and the price of the service has increased by $7 per month. How much of this $7 increase is due to a general up-tick in inflation, and how much is due to quality improvements? After all, inflation is the price increase of a fixed basket of goods and services. There is no inflation if the higher price buys you more or better stuff.

The market basket of goods and services the BLS uses to measure inflation is fixed (although that will soon change, as I'll explain shortly). Consumers cannot substitute a "basket" good whose price has risen for a lower priced "non-basket" good. This situation leads to what is known as substitution bias.

As time passes, some prices rise more than others. Since 1983, for example, shelter costs have risen more than 80 percent, while apparel prices have increased only 24 percent. Buying fewer expensive items and more of those that have had smaller price increases is a natural process for most people, but it isn't natural for the BLS. The CPI assumes that the market basket that households buy does not change. This means that items whose prices have risen most receive too much weight in the index (because households substitute away from them), while those whose prices have risen least are given too little weight (because households shift their spending toward them).

In other words, the savings that households obtain by substituting cheaper items for more expensive ones are not captured by the index, which, as a result, shows more inflation than households actually suffer. This bias grows larger over time.

On December 4, 1996, the Advisory Commission to Study the Consumer Price Index (a.k.a. the Boskin Report, named after the commission chair, Michael Boskin) completed an exhaustive review of the CPI. This report estimated that the substitution bias effect causes the CPI to overstate inflation by as much as 0.4 percent per year. Taking into account other reporting difficulties -- such as quality bias, which equals 0.6 percent, and store switching bias, which equals 0.1 percent -- the overstatement grows to an estimated 1.1 percent per year. Compounded over a long enough period of time, this becomes a huge problem.

The BLS is working on reducing the biases detailed in the Boskin Report. To learn more on proposed changes to the CPI, read the Federal Reserve Bank of San Francisco's brief and informative summary in its "Economic Letter: A Better CPI." Some of the BLS changes have already been implemented.