FRBSF Economic Letter
2003-24; August 22, 2003
Improving the Way We Measure Consumer Prices
Paying attention to consumer prices is a key aspect of central banks'
efforts to maintain low and stable inflation. However, measuring consumer
prices is not a straightforward or unambiguous procedure. Indeed, the
consumer price index (CPI), which is produced by the Bureau of Labor Statistics
(BLS), has undergone a series of refinements in recent years. Furthermore,
in August 2002, the BLS began publishing a new aggregate price index called
the Chained Consumer Price Index for All Urban Consumers (C-CPI-U). This
new chained index is designed to be a better measure of consumer prices
and the "cost-of-living" than the traditional CPI. This Economic
Letter examines the details and recent behavior of this new index
and compares it with other consumer price measures.
Solving the problem of "substitution bias"
Coming up with a single measure that tracks changes in the prices of
all the commodities consumed in the U.S. over time is difficult for several
reasons. For instance, new items are constantly being introduced, existing
items are constantly being improved, and consumer preferences may be changing
as well. These changes complicate the task of constructing a price index
because they lead to changes in the prices of these commodities and the
quantities consumers purchase.
One particular complication is called "substitution bias."
For example, when the price of computers falls while the price of books
stays the same, consumers might well buy more computers than books. If
the price index uses weights based on the relative expenditures on these
two items before the price change, the cost of living would be overstated
because consumers are spending relatively less on books than before. This
problem is known as "substitution bias" because the price index
does not reflect consumers' substitution between computers and books.
Substitution bias is a significant flaw in the traditional CPI, which
uses expenditures in the base period as fixed weights.
Before 1999, substitution bias affected both the "lower level"
and the "upper level" tiers of the index. At the "lower
level," the CPI aggregates the price quotes within an item category
in each of the CPI sampling areas, for example, the prices of merlot and
chardonnay within the category of "wine" in Minneapolis. At
the "upper level," the CPI aggregates over 8,000 category-area
strata (composed of all possible combinations of 211 item categories and
38 areas), for example, the price of "breakfast cereal" in Pittsburgh
and the price of "hospital services" in St. Louis. According
to the Advisory Commission to Study the Consumer Price Index, "lower
level" bias caused annual inflation to be overestimated by about
0.25 percentage point while "upper level" bias led to an additional
overestimation of about 0.15 percentage point (for a complete range of
estimates of these biases, see Table 1 in Lebow and Rudd 2003).
In 1999 the BLS introduced into the traditional CPI a geometric mean
aggregator for averaging prices within most item categories (that is,
at the "lower level"). This new procedure is designed to reflect
consumers' responses to relative price changes within these item categories
and to mitigate "lower level" substitution bias. With the C-CPI-U,
the BLS has taken another step forward. This index uses expenditure data
in both the base and the current period in computing the weights, and
that helps mitigate the "upper level" substitution bias.
Since the composition of C-CPI-U requires using expenditure data in the
current period, and since these data are available only with a lag, the
initial release of the C-CPI-U is termed preliminary and is followed by
two revisions, the first labeled "interim" and the second labeled
"final." For instance, in January 2003, the BLS published the
preliminary index for that month, the interim index for all of 2002, and
the final index for all of 2001. The C-CPI-U is issued only at the national
level and is not seasonally adjusted. (Note that the traditional CPI is
not revised, so its values are "final" upon release.)
Some surprises with the new index
A recent BLS announcement indicated that the differences between the
inflation measures implied by the C-CPI-U and the CPI-U (that is, the
traditional CPI for All Urban Consumers) are notably larger than expected.
In particular, the BLS expected the annual C-CPI-U for 2000 to be about
0.1-0.2 percentage point lower than the CPI-U; instead, the final release
was 0.8 percentage point lower.
Several factors may help to explain the large divergence. One factor
could be changes in the structure of consumers' expenditures. In 2000,
the CPI-U's underlying expenditure weights were about six years old. Analysis
by the BLS shows that, if 1997-1998 weights were adopted in the calculation,
the CPI-U index would have increased by 3.3% instead of 3.4%, and the
gap between the C-CPI-U and CPI-U inflation measure would diminish by
0.1 percentage point. It should be noted that the BLS plans to update
the CPI-U expenditure weights more frequently and will make the average
weights three years old.
Second, and more important, relative prices diverged more than usual
during the late 1990s; consequently the substitution bias was larger than
average. For instance, in 2000, the December-to-December CPI-U index for
personal computers and peripheral equipment dropped by 22.7%, while the
index for utility natural gas rose by 36.7%. A simulation study reported
in The BLS News (2002) shows that, if these two component series
were excluded from the calculations, the 2000 C-CPI-U inflation measure
would remain at 2.6% since the price increase for natural gas and the
decrease for the information-processing category cancel each other out.
By contrast, the estimates for the 2000 CPI-U inflation measure (based
on 1997-1998 weights) would be lowered from 3.3% to 3.0%; therefore the
divergence between the CPI-U and C-CPI-U inflation measures would be only
0.4 percentage point.
Comparing the PCEPI and the C-CPI-U
 The
Bureau of Economic Analysis (BEA) of the Department of Commerce produces
another major chain-weighted price index, the personal consumption expenditures
price index (PCEPI). Much of the price data used in constructing this
index comes from the CPI. Figure 1 shows that the C-CPI-U is closer to
the PCEPI than it is to the CPI-U. For instance, between December 1999
and December 2000, the published PCEPI rose 2.5%, only 0.1 percentage
point less than the C-CPI-U increases.
Nonetheless, there are important differences between the C-CPI-U and
the PCEPI, so the two indexes should not be expected to move closely together
over time. First, the PCEPI is considerably broader in scope than the
C-CPI-U. The PCEPI covers expenditures by nonprofit institutions, such
as churches and religious groups, as well as items like employer-paid
insurance and Medicare expenditures, which are excluded from the CPI because
they are not out-of-pocket expenditures for consumers.
Second, some of the indexes' underlying measures of prices are different,
often reflecting their differences in scope. For instance, the PCEPI tracks
the costs of doctors' services with a producer price index measure that
reflects all payments to doctors rather than just consumer expenditures.
Moreover, in cases where the actual transactions are hard to observe,
the BEA formulates its own estimates of the "imputed" prices
to approximate the nonmarket prices. Some imputed prices are extremely
volatile and can have a substantial effect on movements in the overall
PCEPI.
Third, their weights are different. Because the PCEPI and the CPI differ
quite substantially in scope, one would expect the price of the same commodity
to be weighted differently in the two series. For instance, the category
of medical care accounts for a larger share of the PCEPI simply because
the CPI covers only out-of-pocket medical expenditures. More fundamentally,
the two sets of weights are derived from very different sources. The CPI
weights are derived from expenditures reported by households in the consumer
expenditure survey, while the PCEPI weights are the expenditures as reported
by businesses.
These differences are substantial and suggest that the C-CPI-U should
provide a valuable, independent measurement of consumer prices.
Tao Wu
Economist
References
BLS News. 2002. "Consumer
Price Indexes." Department of Labor, Bureau of Labor Statistics
(August 16). http://www.bls.gov/cpi/home.htm
Lebow, David, and Jeremy Rudd. 2003. "Measurement
Error in the Consumer Price Index: Where Do We Stand?" Journal
of Economic Literature (March) pp. 159-201.
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