Use and Misuse of the Consumer Price Index

Article excerpt

To paraphrase my grandfather, a dollar doesn't go as far as it used to. This is one of the oldest saws in economics, so often used that we accept it as truth. The time value of money is central to modern financial theory, and is the foundation of indexing that applies to entitlement programs, tax brackets, rents, and (in some cases) pay.

Yet many are now arguing that a dollar goes a lot further than we think. Having come full circle in our 25-year battle against the price level, we are now engaged in a reexamination of what inflation is and what role indexing should have in our economy. At the center of the growing debate is our old friend the consumer price index (CPI).

Once a relatively esoteric economic variable, inflation became everyone's business after the oil shocks of the 1970s. Remember Nixon's wage/price freeze? Gerald Ford's WIN (Whip Inflation Now) buttons? To guard against the erosion of purchasing power, many public and private expenditures were structured to escalate in tandem with the price level.

There is no shortage of indicators that attempt to gauge inflation. It is reviewed at the consumer and producer levels, at different stages of production, and across varying collections of goods and services. Which one is best? Well, that's not so much a question of precision as it is of perspective; the different "baskets" covered by each has relevance for different audiences. As to accuracy, none is completely reliable; each series is often revised, and volatile components are sometimes stripped away to allow review of a "core" trend. (Unfortunately, the categories most often eliminated are food and energy, two important ones for most consumers.)

While dissimilar in many ways, the various price indices are all based on a relatively fixed basket of items which can be tracked through time. This basket is updated only periodically (every ten years in the case of the CPI, which currently covers parakeets but not cellular phones), and its consistency is a source of both strength and weakness. Strength because stability tightens comparison with history; weakness in that the basket is slow to keep up with economic evolution. The CPI is particularly slow to recognize consumer substitution away from expensive products, and does not keep perfect pace with quality improvements that mitigate higher prices.

To address these perceived shortcomings, a blue-ribbon commission suggested last fall that the CPI overstates changes in the cost of living by about 1%. …