Understanding the Market

[If you would like a brief review of ways to measure inflation and the most important U.S. monthly inflation indices you should read Understanding Inflation Data: An Introduction first and then return to this article that is about the CPI, the consumer price index]

The CPI or the Consumer Price Index is published by the Bureau of Labor Statistics (the BLS) an independent agency of the U.S. federal government. The BLS publishes CPI data in the middle of the month after the data were collected (data for June 2008 will be released on July 16; see here for the release schedule).

The CPI-U index (often referred to as the CPI or headline inflation number; there is much information here) measures prices for the average urban household, representing about 87% of US consumers (the index does not measure prices paid by people living on farms or in rural areas).

The BLS calculates the basket of goods consumed by urban residents conducting interviews of around 30,000 households; they include about 200 categories of goods including a sample of 80,000 individual items. The weights of these items in the basket is now adjusted every two years. There is a fair amount of controversy about the categories contained in the sample (in particular concerning how the price of housing is measured, see here for the detailed explanation by the BLS; the issue is that the BLS tries to compute how much it costs to live in a house but tries to exclude the gains and losses experienced by homeowners as investors in housing)

, but in general the BLS chooses certain items, such as a 4.4 pound bag of golden delicious fancy grade apples to represent the apples category and then adds all the prices together (divided by their weight in the consumption basket) to arrive at a price index.

As technology changes it becomes very difficult to measure the market basket. New products are introduced every year (how much did an iPhone cost 2o years ago? see here for a nice comparison of a 2008 model iPhone and a state of the art 1988 Motorola DynaTAC 8000X that cost $4000 when first released) and the BLS must change the basket of goods frequently to keep up with consumers.

In 1996 the Boskin Commission report found that the CPI overstated inflation by about 1.1% due to biases related to substitution

, new goods and quality change. At the time there was general consensus that the CPI overstated inflation, but much disagreement about the magnitude. Substitution bias means that when the price of one good (say Coca Cola) rises, consumers will buy more Pepsi Cola or other similar soft drinks without being much worse off; an index that assumes that the basket does not change will overstate inflation. New goods and quality change speak to the problem of measuring the price difference between the latest iPhone and its predecessors.

Other studies found a bit less bias but still believed that CPI was too high (see here for a review of later studies). More recently critics of the CPI such as Bill Gross (see here and here) have argued that the BLS overcorrected and now the CPI understates inflation; but there are others (see here) who believe that the CPI fairly accurately reflects the inflation picture.

It is important to remember that the CPI is an attempt at measuring the level of prices for an urban consumer and that the composition of the urban consumption bundles has changed dramatically in the last 40 years. There has been an explosion in the number of new products; the number of products in supermarkets has increased from around 8

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,000 in 1970 (see here) to around 45,000 today (see here) and the internet allows consumers access to a much wider set of retailers. While the CPI might accurately capture the average prices paid by urban consumers, differences in consumption bundles have certainly increased. Further, consumers are especially aware of food and gasoline prices and seem less aware of service prices (how much are you paying per channel for cable/satellite TV versus a few years ago? The price has probably gone up but so has the number of channels) . Complaints about the accuracy of the CPI are likely to be greatest when (as is the case now) food and energy prices are rising rapidly. It is probably safe to conclude that complaints about the CPI’s accuracy are likely to increase over time along with the diversity of consumer bundles purchased.

This entry was posted on Tuesday, June 24th, 2008 at 4:24 am and is filed under Economy. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.