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Explaining the Consumer Price Index 1 (June 2007)

handle is hein.congrec/cbo9571 and id is 1 raw text is: A series ofissue summaries from the Congressional Budget Office JUNE 20, 2007 Explaining the Consumer Price Index The consumer price index for all urban consumers (CPI-U) is the best-known official measure of inflation. Published monthly by the federal Bureau of Labor Statis- tics (BLS), the CPI-U tries to approximate changes in the cost of living-that is, changes in the cost of maintaining a constant standard of living from one month to the next. To construct the CPI-U, BLS surveys the prices of thou- sands of goods and services (the index has more than 200 categories of items) in 38 regions, averaging the results to form a nationwide estimate of inflation. Over the past five years, the cost of living, as measured by the CPI-U, has varied but, on average, has risen by about 234 percent per year (see Figure 1).1 The purpose of this brief is to explain some of the meth- ods used to construct the CPI-U and why, in some cases, the index's estimates of inflation may differ from consum- ers' perceptions of how much prices are rising.2 The brief focuses on six aspects of the CPI-U's construction: aver- aging regional price indexes to create a nationwide index; estimating the expenditure weights that BLS assigns to the major categories of prices in the CPI-U to account for the categories' relative importance; allowing for shifts in 1. Other measures of inflation have risen at roughly similar rates in recent years. Those measures include the consumer price index for urban wage earners and clerical workers, which is used to adjust Social Security benefits for inflation, and the personal consump- tion expenditure chained price index, which is computed by the federal Bureau of Economic Analysis. 2. Recent articles in the popular media have discussed the validity of the CPI-U and whether it reflects the inflation that consumers actually experience. See, for example, Floyd Norris, What Hap- pens If Inflation Is Overstated? New York Times, June 9, 2006, p. Cl; David Wessel, Why Inflation Seems to Have Sharper Teeth Than the CPI Suggests, Wall Street Journal, March 16, 2006, p. A2; Daniel Gross, How Home Prices Can Be Hot but Inflation Cool, New York Times, June 26, 2005, section 3, p. 5; and New and Improved: An Inflation Debate Brews Over Intan- gibles at the Mall; Critics Say U.S. Plays Down CPI Through Adjustments for Quality, Not Just Price; Value of a TV's Flat Screen, Wall Street Journal, May 9, 2005, p. Al. This brief was prepared by Adam Weber and John Peterson. It and other CBO publications are available at the agency's Web site (www.cbo.gov). Peter R. Orszag Director relative prices, a phenomenon known as economic substi- tution; adjusting for changes in the quality of various goods and services; measuring prices for medical care; and measuring prices for shelter. Two criticisms of the CPI-U are not discussed. One is the necessary limitations of the index: Despite its broad cov- erage of prices, the CPI-U does not track the cost of many factors that affect a person's well-being-for exam- ple, crime, traffic, pollution, the prevalence of disease, the quality of education, and civil liberties. Cost-of-living measures rarely include such factors because few market prices or consumer expenditures are associated with them, making it essentially impossible to define and measure changes in their price or value. A second criticism of the CPI-U is that, for technical rea- sons, the index may overstate changes in the cost of liv- ing. Such arguments of upward bias were stronger in the 1990s, before BLS instituted a number of technical improvements. Some analysts argue the opposite, that the CPI-U actually understates inflation.3 Those criticisms go beyond the scope of this brief. 3. See Robert J. Gordon, The Boskin Commission Report: A Retrospective One Decade Later, NBER Working Paper No. 12311 (Cambridge, Mass.: National Bureau of Economic Research, June 2006), available at http://papers.nber.org/papers/wl2311; and David S. Johnson, Stephen B. Reed, and Kenneth J. Stewart, Price Measurement in the United States: A Decade After the Boskin Report, Monthly Labor Review (Bureau of Labor Statis- tics, May 2006), p. 11, available at www.bls.gov/opub/mir/2006/ 05/art2full.pdf.

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