FRBSF Economic Letter
99-05; February 5, 1999
 Economic
Letter Index
A Better CPI
The monthly consumer price index (CPI) is the most oft-cited measure
of inflation and one of the most important and closely watched statistics
in the U.S. economy. It is an indicator of how well the Federal Reserve
is doing in achieving and maintaining low inflation, and it also is used
to determine cost-of-living adjustments for many government programs,
collective bargaining contracts, and individual income tax brackets.
Since 1995, the Bureau of Labor Statistics (BLS) has been eliminating
biases that cause the index to overstate inflation, and further changes
will come in January 1999. These changes are expected to create a more
reliable index and by 1999 will have lowered measured CPI inflation by
more than half a percentage point. Although this may seem like a small
change, the effect of these changes is permanent so that measured inflation
will be lower by this amount in all future years.
It is important that the CPI should measure inflation accurately or that
the degree of bias be known. Macroeconomic policymakers such as the Fed
then can take appropriate steps to keep inflation low, and the public
can be informed about their successes and failures in achieving their
goal. Also, if the CPI does not measure inflation correctly, cost-of-living
adjustments based on it will have different effects from those desired
when the commitments to make these adjustments were made. For example,
adjusting Social Security benefits based on an upwardly biased CPI may
shift spending power from the young toward the old.
This Economic Letter will explain the types of biases that cause
the CPI to overstate inflation, BLS actions to remove these biases, and
the possible implications for monetary policy.
Sources of bias in the CPI
The BLS has been studying possible biases in the CPI for a long time.
The issue gained national prominence in 1996 when the Congress commissioned
a panel of experts on price measurement issues, chaired by Michael Boskin
of Stanford University, to examine biases in the CPI. Their report, "Toward
a More Accurate Measure of the Cost of Living," identified four major
sources of bias and estimated that they caused the CPI to overstate inflation
by 1.1 percentage points per year at that time.
Substitution bias. Substitution bias occurs because the CPI
measures the price changes of a fixed basket of goods and services
and thus does not capture the savings that households enjoy when they
change their spending in response to relative price changes of goods and
services. For example, a rise in the price of beef leads people to buy
more chicken in order to keep their food costs down. The Boskin report
identifies two types of substitution bias. The first, estimated to raise
measured inflation by 0.25 percentage point annually, is lower-level
substitution bias and occurs when consumers substitute between similar
items within a category (e.g., substituting between pippin and gala apples).
The second type, estimated to boost inflation by 0.15 percentage point
annually, is called upper-level substitution bias and occurs
when consumers substitute between items from different categories (computers
for television sets, for example) in response to price changes.
Currently, the market basket that is priced is updated approximately
once a decade. The new basket, based on consumers' purchases in 1993-1995,
was introduced into the index earlier last year. As we move further away
from this date, upper-level substitution bias may increase as spending
patterns move away from the basket on which the present CPI is based.
Outlet bias. This type of bias is similar to substitution bias,
but refers to where households shop rather than to what
they purchase. Over the past 15 years, for example, the growth of discount
stores has helped consumers lower their expenditures by offering high-volume
purchases at reduced prices. The expansion of these establishments has
not been adequately represented in the CPI, thus creating an upward bias
of prices estimated at 0.1 percentage point per year. A similar problem
may arise in the future as shopping online becomes more widespread.
New product bias. This bias occurs because new products, such
as VCRs and cellular phones, are not introduced into the index until they
are commonplace items. This means that the substantial price decreases
and quality increases that occur during the early years following introduction
are not captured by the index. A problem of dealing with this bias is
that the BLS can never know in advance which of the many new products
introduced each year will be successful and hence worthy of inclusion
in the CPI.
Quality bias. This bias arises because some of any increase
in the price of an item may be due to an improvement in quality, rather
than being a pure price increase. For example, when car prices rise, this
may be due to the addition of seat belts, air bags, or anti-smog devices,
or to pure price inflation. In the case of cars, the BLS often uses the
price of the new item as an optional feature before it becomes standard
equipment as an indicator of what the improvement is worth to consumers.
Quality improvements in other areas--such as medical care--are more difficult
to measure so that bias is more likely to occur. And features of a product
that become mandatory--such as seat belts, which buyers are forced to
purchase even if they would prefer not to--are particularly difficult
to handle.
The combination of quality bias and new product bias was estimated by
the Boskin Commission to boost measured inflation by 0.6 percentage points
annually. Any estimate of this magnitude, though, is inherently subjective
and subject to debate.
Changes in the CPI since 1995
The BLS began to address the bias in the CPI even before the Boskin Commission
was convened. For example, in 1995 the BLS introduced a new sampling procedure
to determine which outlets to visit to obtain price data for specific
items and what weights to apply to those item prices. The old procedure
put too much weight on items that were temporarily cheap at that outlet,
so when their prices rose back to their normal level, this registered
as an increase in inflation. That same year, the BLS also revised sampling
methods to remove the effects of substituting between brand drugs and
generic drugs. In 1997, the BLS adopted some of the procedures used to
measure hospital prices that are used in the producer price index.
Spurred by the work of the Boskin Commission, the BLS introduced further
changes to confront substitution and outlet bias. The BLS has sought added
funds to update the commodity and outlet samples more frequently and to
do so at lower cost. Updating the commodities and the outlets more often
should reduce substitution bias by allowing the published index to include
more of households' responses to observed price changes. There also have
been attempts to reduce quality bias. For example, the BLS is expanding
the use of hedonic regressions to compare quality differences. Hedonic
regressions attempt to estimate econometrically the value that households
put on quality differences. These methods are currently used for measuring
quality distinctions in the categories of apparel, rent, and computers
and peripheral equipment, and as of January 1999, they will be used for
television prices. Research is underway to extend this technique to other
categories.
Planned changes
Future changes will address substitution and new product bias further.
Beginning next January, the BLS will attempt to reduce lower-level substitution
bias by using a geometric mean formula to calculate price changes for
many of the basic categories of the CPI. The geometric mean formula assumes
the household spends the same proportion of its outlays on each category;
the arithmetic mean, which is now in use, assumes the household always
buys the same quantity of each item. Using the geometric mean implies
that if the price of pippin apples rises 10%, the quantity of pippins
bought decreases 10%, so that the average household spends the same amount
on pippins. This assumption is, of course, arbitrary, but it may give
a better overall result than the assumption of no substitution. The BLS
has estimated the monthly CPI using both methods over the past few years
and concluded that adopting the geometric mean formula will reduce measured
inflation by about 0.2 percentage point annually (the Boskin Commission
estimated that lower-level substitution bias raised measured inflation
by about 0.25 percentage point). The new formula will be used to calculate
inflation in most categories in the CPI except those in which consumers
cannot easily substitute between alternatives when there is a relative
price change: for example, no change in relative prices would cause a
person with a heart problem to consider buying a hearing aid. The new
approach will be used only to aggregate price changes of individual commodities
into broad commodity groups; these groups will continue to be aggregated
into the overall index using fixed-quantity weights. After this change
has been completed, the reduction in measured inflation due to methodological
changes since 1995 is estimated to be 0.6 percentage point.
The BLS will update more frequently the expenditure weights obtained
from the Consumer Expenditure Survey. The BLS is in the process of deciding
how often the weights will be updated and wishes to increase the sample
size of the survey to allow the use of only two years of expenditure data
to construct the weights. These changes will make the market basket more
representative of what consumers are actually purchasing and will introduce
new products in a more timely manner.
To tackle upper-level bias more extensively, the BLS will produce an
official "superlative index" starting in 2002 in addition to
the CPI. This term--originally coined by Canadian economist, Erwin Diewert--refers
to an index that approximately removes all substitution bias for most
assumptions about household preferences. One superlative index is the
Fisher ideal index, which uses a combination of weights from both the
original market basket and the current market basket to take into account
changes in consumer spending patterns. A version of this method is currently
used in constructing the national income and product accounts. A superlative
index would be subject to revision unless it were published with a time
lag, because it takes time to gather data on current expenditures; thus,
the CPI cannot be converted to a superlative index. However, recent research
suggests that if the current market basket were initially represented
by the basket for the previous year, the degree of subsequent revision
required would be small.
Implications for public policy
Since the Fed uses the CPI as an indicator of price inflation, a more
accurate index should make anti-inflationary monetary policy more effective.
The public will have a better indicator to check how well the Fed is doing
its job. The effect on policy is not likely to be large, however, because
the Fed already takes account of the best available estimate of the remaining
biases in the published data. On the other hand, when inflation was higher,
modest errors were less important since it was always appropriate to make
policy with a view to reducing inflation. But now that we are closer to
zero inflation, an accurate measure is more important, especially if policymakers
wish to avoid a situation where actual inflation is negative. Under the
Boskin Commission estimate of a total upward bias of 1.1 percentage points,
a goal of zero inflation would be equivalent to an actual goal of -1.1%.
Some economists argue that negative inflation is undesirable in the long
run. If it is difficult to reduce nominal wages, then it may not be possible
to lower individual workers' real wages if prices are not rising. This
may mean that it is difficult to provide appropriate incentives to move
unneeded workers into other lines of work where they are more useful.
Similarly, declining prices may cause the real value of debts to rise,
which could cause some otherwise sound businesses to fail. Finally, if
we want our tax and transfer system to be invariant to inflation, an accurate
CPI is essential, so that the task of adjusting tax and transfer payments
to price changes can be done quickly, easily, and without undue dispute.
Conclusion
Ongoing research is necessary to identify biases in the CPI. Changes
to this index are inevitable as the BLS strives to maintain an accurate
measure of inflation in our dynamic economy. By 1999, about half of the
bias identified by the Boskin Commission will have been removed. Although
the changes may be inconvenient--because they make the current index less
comparable with the past index--they will lead to an improved measure
of actual inflation and, thus, a better CPI.
Alison Wallace
Research Associate
Brian Motley
Research Officer
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
|
