Myths and Misconceptions About the CPI

Guest Author: Mark J. Perry, Ph.D. is Visiting Scholar at The American Enterprise Institute and Professor of Finance and Business Economics, School of Management, University of Michigan-Flint.  He writes at Carpe Diem, where this article first appeared.  VITA

From the 2008 BLS Study “Addressing Misconceptions About the Consumer Price Index” written by John Greenlees and Robert McClelland, research economists in the BLS Division of Price and Index Number Research:

“A number of longstanding myths regarding the Consumer Price Index and its methods of construction continue to circulate; this article attempts to address some of the misconceptions, with an eye toward increasing public understanding of this key economic indicator.
Within the past several years, commentary on the CPI has extended well beyond the circle of economists, statisticians, and public officials. The strongest criticism of BLS methodology has not been concentrated in a single profession, academic discipline, or political group, but comes instead from an array of investment advisers, bloggers, magazine writers, and others in the popular press. Also, whereas in the past the CPI frequently was held to be overstating inflation, recent criticism has focused on supposed downward biases.”

Conclusions from the paper about four CPI myths:

1. It is a myth that the BLS reduced the growth rate of the CPI by assuming that hamburger is substituted for steak – it must be stated unequivocally that the BLS does not assume that consumers substitute hamburger for steak.

2. It is a myth that the use of hedonic quality adjustment has substantially reduced the growth rate of the CPI.  This myth represents a fundamental misunderstanding of the hedonic method, and it ignores the fact that the introduction of all hedonic quality adjustments since 1999 has had only a very small impact on the overall CPI.

3. It is a myth that the 1983 adoption of owner’s equivalent rent systematically reduced the growth rate of the CPI shelter index.

4. It is a myth that Social Security payments are updated by a CPI that does not include food or energy.

Each of the improvements made to the CPI over the years is based on sound economic theory and years of research by academicians and BLS economists. The methods continue to be reviewed by outside commissions and advisory panels, and they are widely used by statistical agencies of other nations.

On another note about general consumer confusion about inflation based on their frequent purchases of gas and food and infrequent purchases of most other components of the CPI:

“Many consumers feel that their personal inflation experiences are not reflected in the movements of the CPI-U. These experiences can actually be borne out because some consumers spend more than others on items with rapidly increasing prices. The CPI-U is constructed from expenditures averaged over many consumers; as a consequence, some consumers will face a lower rate of inflation than that indicated by the CPI-U, and others will face a higher rate of inflation.

The BLS quotes David Leonhardt in the NY Times: “Price increases are simply more noticeable—more salient, as psychologists would say—than price decreases. Part of this comes from the notion of loss aversion: human beings dislike a loss more than they like a gain of equivalent size. You hate that ground chuck now costs $2.83 a pound, but you didn’t notice that oranges are 31 percent cheaper than they were a year ago.

(MP: To use a more recent example, how many consumers have noticed that eggs are 7.5% cheaper than a year ago?)

Conclusion from the BLS: “Finally, the CPI is not, and can never be, a perfect index. Moreover, all of the topics raised in the recent commentary on the CPI—including the methods for dealing with consumer substitution, quality change, and owner-occupied housing—are critically important to the accuracy of the index. The very existence of the CPI methodological changes discussed here attests to the fact that the BLS must always be working to enhance the index. The BLS benefits from the work of academics and others who identify ways in which the CPI can be improved. The BLS also benefits when the public understands how the CPI is constructed and what the index’s strengths and limitations are. It is hoped that this article will help increase that public understanding.”

MP: I believe that the BLS is conscientiously and objectively performing a very difficult and challenging job of calculating a consumer price index, despite conspiracy claims that the government is engaged in politically-motivated distortions of the CPI to either over-state or under-state “real” inflation to meet some political goals or objectives.  And compared to other countries around the world, I would suggest that the CPI calculated in the U.S. is probably the “gold standard” in terms of its reliability, consistency, transparency and its lack of politically-motivated distortions.

2 replies on “Myths and Misconceptions About the CPI”

  1. I don’t know about “systematically,” but it is surely true that the run-up in housing prices during the first part of the aughts completely escaped the CPI.

  2. demand side – – –

    A basic problem that our econometric measurements have is that asset prices are not properly accounted for. The CPI is just one of the measurements that has deficiencies on that account. The Fed totally missed the inflation that was taking place in home prices during the bubble because they were not looking at that particular inflation.

    Dirk Bezemer has written a seminal paper that I have reviewed which studied the characteristics of those few economists who were warning of an economic problem in the 2000-2006 time frame. He found that they all, one way o anither, were using accounting concepts to weigh the impact of asset bubbles on distortion of the economy.

    The link to my discussion of what Bezemer wrote is http://econintersect.com/wordpress/?p=2648
    (This article was also posted at Seeking Alpha 1.5 to 2 years ago.)

    Bezemer’s conclusion is that we need to implement macroeconomic cash flow account metrics of economic activity instead of just measuring the components of GDP and consumption. He says it is a serious flaw to be assuming that assets are simply tools of the economic process – they have become part of it.

    I am seriously over-simplifying Bezemer’s proposal here, but I hope you get a general idea. The article does a better job of drawing out the thesis in more detail.

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