Friday, April 19, 2013

CBO Explains Differences Between Traditional And Chained Inflation Indexes: Chained CPI About 0.25 Percent Lower Per Year Than Traditional CPI

Posted by Milton Recht:

The President and Congress are considering switching inflation indexing in the US tax code and in inflation adjusted benefits, such as Social Security, from the Traditional CPI to the Chained CPI to increase future tax revenues and to lower future benefit payment increases.

From Congressional Budget Office, "Differences Between the Traditional CPI and the Chained CPI" by Rob McClelland on April 19, 2013:
The Traditional CPI
The traditional versions of the CPI are based on spending patterns from a point in the past, and so do not fully incorporate the effects of consumers’ substitution between various goods and services when their relative prices change. As a result, those traditional versions of the CPI overstate the amount by which consumers’ well being declines when prices rise and understate the benefit of reductions in prices. Therefore, the traditional versions tend to grow faster than the cost of living does.

The traditional versions of the CPI also suffer from a statistical bias that occurs because the index is calculated using prices for only a small portion of the items in the economy.
The Chained CPI-U

BLS has developed another approach to measuring price increases that avoids both substitution bias and small-sample bias. Since August 2002, BLS has published an alternative index, the chained CPI-U, which attempts to account for the effects of substitution on changes in the cost of living. The chained CPI-U provides a more accurate estimate of changes in the cost of living from one month to the next by using market baskets from both months, thus “chaining” the two months together.

The chained CPI-U is also largely free of small-sample bias because of the way in which it is computed. Both the traditional CPI and the chained CPI-U are based on the same item-area indexes, which are calculated using a geometric average. To combine those indexes into an overall estimate of price growth in the United States, however, BLS uses a geometric-average formula for the chained CPI-U, as opposed to an arithmetic average formula for the traditional CPI. The use of a geometric-average formula to combine the item-area indexes effectively makes the number of elements in the geometric average much larger, which essentially eliminates small-sample bias.

The chained CPI-U results in lower estimates of inflation than the traditional CPI does. CBO expects that annual inflation as measured by the chained CPI-U will be about 0.25 percentage points lower, on average, than annual inflation as measured by the traditional CPI. That estimate is based in part on the observed past differences between the chained CPI-U and the traditional CPI-U and CPI-W. [Emphasis added.]

The difference has generally been smaller when overall inflation has been lower—perhaps reflecting fewer increases in the relative prices of goods and services for which consumers spend a great deal and less interest by consumers in substituting between goods and services when price increases are mostly smaller. In addition, the gap between the traditional and the chained CPI-U has generally been smaller when prices for energy have been declining and larger when those prices have been rising rapidly.

Although many analysts consider the chained CPI to be a more accurate measure of the cost of living than the traditional CPI, using it for indexing could have disadvantages. The values of the chained CPI are revised over a period of several years, so affected programs and the tax code would have to be indexed to a preliminary estimate of the chained CPI that is subject to estimation error. Also, the chained CPI may understate growth in the cost of living for some groups, as discussed in another blog posttoday.

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