Who’s afraid of chained CPI?

By Zachary Karabell
December 20, 2012

As the fiscal cliff talks evolve and devolve, the latest spat has been whether the arc of federal spending should be curtailed by changing the way that we assess costs. The proposal from the White House is to switch the way cost-of-living adjustments are made for Social Security benefits. Rather than pegging those to the Consumer Price Index as currently calculated, these would be pegged to a “chain-weighted” Consumer Price Index, which would save as much as $125 billion in additional benefits over the next decade.

Sounds wonky, and it is. But so is much of how the federal government accounts for spending, and these metrics intimately shape what we spend, how we spend, and how we think about the present and the future. The primary measure of inflation, the Consumer Price Index (CPI) uses a fixed basket of goods that resets periodically. Chained CPI uses a basket of goods that adjust more fluidly to account for what statisticians and economists call “the substitution effect.” A fixed basket of goods is easier to calculate: just define the basket and then measure the price changes. But in the real world, people don’t passively accept changing prices. They change their behavior. The price of gas goes up? People drive less; they carpool more; they buy more fuel-efficient cars and consume less gas. The price of a domestic flat screen television goes up? They buy a less expensive import. In short, people don’t necessarily bear rising costs passively; they react and shift to maintain their standard of living. The traditional CPI index doesn’t capture that.

For all its wonkiness, the proposal to change the benchmark used to determine Social Security and various other benefits has engendered attacks from all points on the political spectrum: the left assails it as a backdoor technicality that will increase burdens on the elderly and the less well-off; the right scoffs that Obama’s proposals don’t constitute true deficit or spending reduction but are simply accounting tricks, and the media treats it as politics as usual with the cynical corollary that because almost no one understands what these rules are, it makes it easier to enact them.

Despite ample media scrutiny over the past week, it’s safe to say that this debate is about as arcane as it gets. Almost no one knows the difference between CPI and chained CPI, even if for years the Bureau of Labor Statistics has been compiling multiple varieties of the index, which serves as a proxy for the rate of inflation. One variant is the chained index. There are others, including a special index for cost-of-living for the elderly and for CPI minus the volatile effects of energy and food (known as Core CPI). All of these use quarterly surveys of 7,000 families about prices paid for 211 different consumer goods in 38 different regions, for a total of 8,018 data points. That is how we assess inflation: whether those data points are going up or down, month-to-month. Every two years, that basket of goods and their weight in the index is adjusted.

Long before the current imbroglio, there have been questions about how inflation is calculated. Statisticians have understood the issues about “substitution effect” for years. In fact, they understood that when these indices were created. In the 1920s, Irving Fisher of Yale argued that the “ideal index” of prices would be a blend of fixed baskets of goods and something that captured how behavior changes in real time. The problem is that the fixed basket is easier to calculate and less costly. That is what the BLS adopted in the 1940s and what has been the standard ever since. In turn, Social Security benefits were pegged to the index, with cost-of-living adjustments based on what the official CPI reported.

Now comes the White House saying: ‘Hey, let’s base those increases not on CPI as it emerged in the 1940s but on “chained CPI.”’ Overall, the chained CPI or any chained index that accounts for how people react to higher prices tends to report less “inflation,” hence the $125 billion in savings.

The proposal has plenty of precedents. The BLS in 2002 began calculating an alternate CPI (called the C-CPI-U), a chained CPI, which is precisely the metric that the president now suggests. It did so after decades of criticism that its methodology was too brittle and did not capture prices as they are actually experienced and then offset by consumer behavior. In fact, in the 1990s, the Federal Reserve under then Chairman Alan Greenspan decided to base its interest rate decision more on what is known as the Personal Consumption Expenditure Deflator reported by the Bureau of Economic Analysis in the belief that it better captured actual inflation than the CPI.

So if your head is spinning with all of the acronyms, let alone the inside-baseball methodology, the larger point is that this thing we call “inflation” has never been a simple number. Few people over the past decades believe that inflation has been truly tamed. The headline numbers say that inflation has been increasing at a modest 2 to 3 percent for the past two decades, but most people believe that the cost of living has been much greater. They experience daily the gap between their needs, wants and income. Inflation as a statistic, however, is not concerned with those challenges. It is an attempt to measure prices systemically, and not whether Mr. Smith in Tulsa is managing to balance his expenses and income.

Ever since the Great Inflation of the 1970s, however, inflation has been a metaphor for whether the country is thriving. Clearly – whether this is acknowledged or not – there has been a gap between the expenses many people must bear and the organic ability of the country to grow and meet those needs. Whether that is any greater than it was in the 1950s – the supposed high point of the American century when as much as a quarter of the population lived in poverty – well, that is another question.

What the proposals this week do reveal, however, is how often our understanding of the world is based on official statistics that are themselves limited. Numbers like CPI were never seen by their inventors or by their compilers as absolutes that perfectly answer pressing social questions such as what is a living wage and what is the basic cost of living for an average family. Their flaws were understood from the get-go, and government statisticians have been tinkering with them for decades, fully aware that they are arbitrary and limited.

In essence, these statistics have always been subject to revision. They have always been arbitrary markers attempting to answer thorny issues of whether our economic system is stable and providing people with the means to meet or exceed basic needs and then some. There is nothing sacrosanct about the current measures, and no sacred cows are at risk with the president’s proposal to adjust the CPI to reflect a more fluid measure. It may be inside baseball; it may strike many as yet another cynical way to make future costs evaporate and leave the consequences to those least able to bear them. But in truth, these proposals open up a wealth of possibilities to alter our current spending trajectory with the full knowledge that much of what we take for granted is based on numbers that we invented only a few decades ago and which have always been limited, provisional and subject to improvement. Chained CPI? Bring it on.

PHOTO: An American flag flutters in the wind next to signage for a United States Social Security Administration office in Burbank, California October 25, 2012. REUTERS/Fred Prouser

12 comments

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……so when seniors avoid rising food prices, by omitting fresh food and substituting dog food………..technically, they are spending the same amount for food, and there is no inflation.

isn’t that how chained CPI’s work?

Posted by Robertla | Report as abusive

The issue that all those ‘wonks’ apparently do not understand is that people that live close to the poverty line have always had to employ ‘chained CPI’ methodology to even survive. Then take into consideration that by using that methodology, the lesser amount will continue to compound upon itself, until at age 80, the benefit amount will be at least double digits behind actual inflation. In other words, our poor will become poorer as they age.
The refusal of this country to adequately assist the poor and aging is nothing less than shameful however you dress the numbers.

Posted by jamkarat | Report as abusive

I agree completely with Robertia and jamkarat. I’m 72, and my wife and I depend almost exclusively on Social Security for our “living income”. We have to save some because when one of us dies, the one check left won’t cover the bills. This is a “crack in the “safety net” few couples can avoid.

I agree completely with Robertia and jamkarat. I’m 72, and my wife and I depend almost exclusively on Social Security for our “living income”. We have to save some because when one of us dies, the one check left won’t cover the bills. This is a “crack in the “safety net” few couples can avoid.

Those who would continue to expand our government without limit obviously covet the dollars they must send to those who have EARNED Social Security benefits. And thus “we, the people” in our “golden years” are under relentless assault by both intentional long term devaluation of our dollar and it’s purchasing power and the endless financial “shell game” in Washington.

Neither the present CPI nor the proposed “chained index” are fair in the dictionary sense. The present “push” for a “chained index” is from those who deny Social Security recipients their right to have “their boat” rise in a rising tide. Such was NOT the adopted policy when the program originated.

The current “debate” presumes that it is government outlays that should reduce when TVs or the price of housing goes down. Precisely who has presumed the right to unilaterally decide that seniors are somehow less “deserving” of the financial benefits of globalization as other citizens? We must also remember that the “adopted index” is applicable also to those on Social Security Disability, whose day-to-day needs can differ considerably from retirees.

Why should senior’s dollar income decrease in a declining real estate market if their rent actually rises or if they have a a long term mortgage payment remains the same? Should the government have the power to effectively mandate that, over the years, seniors “substitute” cat food for canned tuna or take half of the prescribed dose of their medications because they lack the funds necessary for the full dose? How much “reacting” and “shifting” is morally acceptable for our government to mandate by progressively and deliberately reducing the purchasing power of EARNED BENEFITS?

When you speak of “numbers…which have always been limited, provisional and subject to improvement…” why is it that those whose well being such changes most affect never seem to have effective advocate or personal voice? “Improvement” according to WHOSE definition?.

if I get to pick what comprises it, I have no problem at all with a “Chained CPI”. If it’s honest and equitable, the cost will be more, not less, than adjustments the present flawed measure produces.

Posted by OneOfTheSheep | Report as abusive

It sounds as if Chained CPI fails to consider additional costs due to e.g. technological change. I would suggest that anyone who cannot access broadband internet is at a serious disadvantage in our society (and before you balk, tell me the last time you were on dial-up and how long it took you to load, say, Reuters home page). Smart phones also seem to be becoming more and more of a necessity (although I have resisted getting one so far).

The larger problem in my view is the fairness view. Our tax structure and other incentives have changed over the past few decades to the benefit of a small slice of society and to the detriment of most. Don’t tell me that taxing the rich won’t solve the deficit problem. That’s not the point. These policies drove us over a cliff (the one in 2008) even while the wealthy benefited and have continued to benefit. So let’s just take some steps to reverse these trends and see where that gets us before we put granny on the catfood diet. Let’s restore Clinton-era tax rates (Reagan era would be even better). Let’s tax cap gains like any other income. Let’s raise the income cap for Social Security contributions. And then let’s see where we are.

Right now, negotiations in Washington are pointing to a deal involving 2% tax increase for working poor and most of the middle class (restoring the payroll tax), while we’re quibbling about a 4% MARGINAL increase on a group of folks who have seen their incomes rise steadily over all these decades. Apart from policy considerations, it’s just plain UNSEEMLY. So no, I’m not on board with this Chained CPI thing or anything else that says that the poor and middle classes have to pay even more for this debacle than they already have before we can squeeze some pittance out of the wealthy.

Posted by Sanity-Monger | Report as abusive

Some things need to be done to firm up social security and chained CPI (or other measures to mitigate excessive COLA adjustments) is one of them. The current CPI has historically been too generous by overstating real inflation. The result has been most workers now receiving way more than they put in, creating a trend that is unsustainable in light of changing demographics (workers per retiree). It is a great thing that social security has COLA adjustments, very few things do. Let’s make it sustainable. A chained COLA and continuing adjustments to the age requirements with increases in the life expectancy are necessary to keep social security outlays on a sustainable basis.

However, adjustments need to be made on the input side as well. Social security tax is extremely regressive. Once you make a certain amount you then pay nothing on the rest. Also much earned income escapes the tax right now – hedge fund carried interests, etc. Wonderful for CEOs and hedge fund managers, but not fair to the 99.99% and not a sustainable course for the country. Maybe we could keep the beneficial effects of the temporary 2% payroll tax break by making it permanent and broadening the revenue base.

Let’s take a balanced approach and do all of the things that I have listed.

Posted by QuietThinker | Report as abusive

This article does everything but explain the issues involved in the various inflation measures, and what their implications are for the current fiscal cliff debate. Merely saying that inflation measures are inevitably “arbitrary” is a cop out.

“Chained CPI” was invented on the idea that regular CPI overstates inflation because it ignores the substitution effect. But the benefit programs that would be cut if cost of living allowances are recalculated using chained CPI mainly affect the elderly, and it is well known that regular CPI does not overstate, but rather understates inflation for them; since their spending is geared more towards housing and medical care.

It is important to note that the average Social Security retirement benefit is only about $1200 per month and a little less than $15,000 per year. 65 % of Social Security beneficiaries rely on it for most of their income, and more than 1/3 rely on it for more than 90% of their income. (figures from Center on Budget and Policy Priorities).

We are thus talking about cutting the incomes of a lot of people who have worked all their lives and who are not particularly well off, just so we make a deal with a very limited tax increase on the rich and still spend $700 billion + per year on the Pentagon. This is called a “balanced approach” to avoiding the “fiscal cliff. But there is nothing particularly wise and circumspect about it.

I also admire Roberta’s illustration of the “substitution effect” (dog food). I appreciate the author’s mention of the great economist Irving Fisher as well.

“Stock prices have reached what looks like a permanently high plateau”–Irving Fisher, October 1929.

There is plenty of food for thought here (substitute or real).

Posted by tizneh | Report as abusive

Retirees spend much more on medical care than younger people. The cost of medical care has outpaced inflation, as gauged by the CPI. Retirees have not been getting adequate cost-of-living increases to benefits, and switching to the chained CPI would only make matters worse.

The Census Bureau has developed a “supplemental poverty measure” (SPM) that is much reasonable than the official measure in the factors it considers. The poverty rate for the 65+ age group is 15.1 percent according to the SPM, versus 8.7 percent according to the official measure. See

https://www.census.gov/hhes/povmeas/meth odology/supplemental/research.html

Posted by OkieRedux | Report as abusive

If we are going to have this conversation let’s start with your basic information

“That is what the BLS adopted in the 1940s and what has been the standard ever since.”

That is incorrect

Why Reported Inflation Seems Different Than Reality

snip

“The original calculation of CPI, which measured the change in the cost of an identical fixed basket of goods priced at prevailing market costs each period, worked reasonably well for the intended purpose into the early-1980’s. However, as the pressure of increasing deficits weighed on political parties, the need to find solutions to reducing spending, without actually cutting spending, led to several substantial changes in the calculation of inflation.

Shortly after Clinton entered the White House the Bureau of Labor Statistics (BLS) altered the calculation of inflation by changing the weighting of goods in the CPI fixed basket. Then, over subsequent years, the method of weighting the underlying components was changed from a straight arithmetic weighting method to geometric. The primary result of the switch to a geometric weighting was a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price which led to lower reported inflation. ”

http://www.streettalklive.com/daily-x-ch ange/1399-why-reported-inflation-seems-d ifferent-than-reality.html

Posted by UselessEater | Report as abusive

What do you substitute for water to drink when your budget gets tight?

Posted by borisjimbo | Report as abusive

All these “solutions” to cut “benefits, entitlements” should have one premise: let’s first apply it to benefits, pensions, and healthcare of our Congress and President, both current and past.

It is so easy for Republicans and Blue Dog Democrats to balance the budget on the backs of poor and middle class because their proposals have no direct affect on their lives. Not a single union employee in the USA, let alone private sector worker has the kind of health care and pension enjoyed by our Senators and Representatives. Furthermore, if we applied a means test (less benefits for higher income and wealthy) none of these past and present elected officials would get any benefits since they are typically of the top 0.5%

What is absolutely amazing to voters who chose Obama is how his administration has been just a Bush3 – more unfunded military spending, low tax rates for multinational corporations, while chipping away bit by bit the livelihood of US middleclass.

Posted by Acetracy | Report as abusive

The problem with the current CPI, chained or otherwise. is the absence of fuel costs. It was removed quite a while ago when oil started to skyrocket. Yet, like any other elephant sitting in the room, it’s presence defeats any attempt to get a handle on an equitable or fair CPI. Every social security recipiant that I know right now has already substituted down to poverty behaviors. What’s left; homeless shelters for seniors?

Posted by bixbysbigsur | Report as abusive

Quote from the article:

“which would save as much as $125 billion in additional benefits over the next decade.”

I hardly believe we are, once again, redefining the measure of inflation to secure a $12.5 billion per year savings.

Posted by Laster | Report as abusive