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Friday, August 26, 2011

The Chained Consumer Price Index: What Is It and Would It Be Appropriate for Cost-of-Living Adjustments?

Linda Levine
Specialist in Labor Economics

The U.S. Bureau of Labor Statistics (BLS) publishes two important measures of inflation: the Consumer Price Index for all Urban Consumers (CPI-U) and the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The CPI might seem like just another economic indicator, but it could be a powerful policy lever. Because the CPI-W is used to calculate annual cost-of-living adjustments (COLAs) to Social Security retirement benefits and the CPI-U is used to calculate annual inflation adjustments to personal income tax brackets, for example, changing the basis of the automatic adjustments could substantially affect outlays and revenues, and thereby, the budget deficit.

As part of its continuing effort to improve measures of change in the cost of living, BLS has since August 2002 been publishing a supplemental measure known as the Chained Consumer Price Index for all Urban Consumers (C-CPI-U). The aim of the C-CPI-U is to produce a measure of change in consumer prices that is free of substitution bias.

One of the difficulties in estimating changes in the cost of living is that consumers often change the goods and services they purchase in response to changing relative prices. In other words, consumers will tend to buy more of those goods and services whose prices are rising slower than average and fewer of those goods and services whose prices are rising faster than average. Substitution on the part of consumers is believed to insulate them from the full effect of rising prices on maintaining their standard of living. Because the CPI-W and CPI-U do not entirely account for substitution, they overstate the impact of inflation on consumer well-being.

As a result of better reflecting consumer substitution, the C-CPI-U has typically increased to a lesser extent than either the CPI-U or CPI-W. This relationship has prompted calls for switching to the C-CPI-U when calculating automatic annual adjustments to inflation-indexed federal programs and individual tax provisions to slow growth in the budget deficit. The “Simpson- Bowles” (National Commission on Fiscal Responsibility and Reform) report included government-wide replacement of the CPI-W and CPI-U with the chained CPI, for example. The committee created by the Budget Control Act of 2011 (P.L. 112-25) may consider the approach during its upcoming deliberations.

That the CPI-W and CPI-U are not revised makes them attractive for use in calculating cost-ofliving adjustments. Unlike them, the C-CPI-U is subject to two revisions after its first release. If the two indexes were replaced by the C-CPI-U, cost-of-living adjustments would either have to wait until the final number was available or rely on preliminary estimates that could change up to two years after the fact. Whether the preliminary C-CPI-U estimates might be attractive alternatives to using the final estimate depends on whether they are biased relative to the final number or if the revisions tend to be significant. If the final index tends to rise more than the preliminary estimates, it might make their use unpopular with those who would be affected. More generally, because increases in the C-CPI-U have tended to be smaller than in either the CPI-W or CPI-U, some Social Security beneficiaries, taxpayers, and individuals whose eligibility for federal programs is based on the poverty threshold (e.g., food stamps) might oppose switching to the CCPI- U.

Date of Report: August 16, 2011
Number of Pages: 13
Order Number: RL32293
Price: $29.95

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