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CPI and COLA

This page is about the extent to which the Consumer Price Index (CPI) is a reasonable basis for Cost of Living Adjustments (COLA).

Summary

19 Feb 2010

CPI does understate, to some extent, changes over time in the cost of a normal standard of living.

With the CPI, the BLS attempts to answer the question, “What is the cost, at this month’s market prices, of achieving the standard of living actually attained in the base period?” To do this, improvements in quality are stripped out of price gains. When TVs started to have remote controls, for example, or doctors started routinely testing cholesterol levels, this philosophy required that any price increases due to the “quality improvement” not be counted as part of inflation. The cost of a higher quality level is never counted, even if it becomes standard.

The stated goal of the CPI is intellectually a very natural one. However there is some mismatch between this definition of CPI and one of its main applications, namely cost-of-living adjustments. People not only want today's standard of living rather than that of the base period, but in many cases there is no choice: one cannot obtain today a car without seatbelts, a computer that can only run MS-DOS, or an annual physical with no mention of cholesterol.

How does CPI compare with actual incomes? A pension with a COLA is probably most often associated with former wage and salary income, and a retirement might typically last 20 years. We looked at growth of CPI, and average growth of wages and salaries, in a moving 20-year window, and found that the growth in income was almost always greater than the growth of the CPI. Thus someone on a CPI-based COLA will almost certainly see the income of his working neighbors outpacing his own.

Graph

8 Jan 2010. Data through 2008.

Wages and salaries were taken from the National Income and Product Accounts table 2.1 line 3 (see table), and normalized by the civilian labor force from the Current Population Survey of the BLS (see table), to obtain wages and salaries per worker. Personal consumption expenditures were taken from NIPA table 2.1 line 28 and normalized by total population line 39 to obtain spending per capita. CPI is the Consumer Price Index for all Urban Consumers, from the BLS.

The increase in each of these was measured in a 20-year moving window, beginning with 1948-1968 and ending with 1988-2008. The main comparison is between wages and salaries per worker, on the one hand, and CPI, on the other. The comparison with spending is distorted by the household sector's increase in debt, and is shown only because it may be important to the psychology of the situation.

Note: Although some private and state pension COLAs are based on CPI-U, the Social Security COLA is based on CPI-W (thanks to Calculated Risk for pointing this out). At the level of the above analysis there is no significant difference between the two.

Highlights

CPI quality adjustments (19 Feb 2010) Quality adjustments remove from the CPI the cost of any improvements in quality, even if they become standard. This is, in fact, required in any intellectually consistent approach using the BLS' definition of inflation. However it is, to some extent, at odds with measuring the cost of living as normally experienced.

With the CPI, the BLS attempts to answer the question, “What is the cost, at this month’s market prices, of achieving the standard of living actually attained in the base period?” To do this, improvements in quality are stripped out of price gains. When TVs started to have remote controls, for example, or doctors started routinely testing cholesterol levels, this philosophy required that any price increases due to the “quality improvement” not be counted as part of inflation. The cost of a higher quality level is never counted, even if it becomes standard.

The audio/video portion of the CPI-U increased 0.6%/yr (compounded) from 1993 to 2008, and IT hardware and services decreased 11.3%/yr from 1989 to 2008 (in both cases, this goes back to the first available data). Autos also steadily decreased in cost from 1997 to 2008.

The stated goal of the CPI is intellectually a very natural one. However there is some mismatch between this definition of CPI and one of its main applications, namely cost-of-living adjustments. People not only want today's standard of living rather than that of the base period, but in many cases there is no choice: one cannot obtain today a car without seatbelts, a computer that can only run MS-DOS, or an annual physical with no mention of cholesterol.

See also