This page provides background information on the US Consumer Price Index (CPI) – mainly what it actually measures, and some limitations.
9 Jan 2010
The main limitation is that the CPI measures the cost of life as it was, not life as it is – the cost of quality improvements, such as new safety features in cars, new medical diagnostics, and improvements in computers, is not counted, even when such improvements become the standard.
Two other aspects of the CPI often provoke complaints, but are not problematic if seen in context. The first is the “Less food and energy” version of the CPI, which is often used as a measure of “core_inflation,” meaning the essential, long-term trend in inflation. While it may appear this is an attempt to ignore the very real cost of energy and food inflation, in fact the change over any ten year period of the “Less food and energy” measure is almost the same as the change in the full CPI; that is, the two only differ in the short term.
“Owner's equivalent rent” (OER) is the amount of rent a homeowner would pay, if s/he were renting rather than owning. The change in OER is assumed to be the same as the change in the rent of nearby units. The complaint is that OER fails to take into account some of the costs of homeownership. This is true; however, the BLS takes the position that the cost of living should only include the cost of shelter, which is covered by OER, and not the cost of speculation in the housing market, which is not. An ideal position, somewhere in the middle, would be difficult to formalize.
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.
Core inflation background (5 Jan 2010) Core inflation is meant to capture the essential trend; in practice it is usually one of the common price indices (e.g. CPI) with the components of food and energy removed.
Central banks attempt to manage inflation, without over-reacting to ephemeral changes. Thus they would like a measure of inflation that gets at the underlying trend rather than short-term fluctuations. This is the motivation for a measure of core inflation.
There are many proposals both for how to define and for how to measure core inflation. However by far the most commonly used measure is simply one's favorite headline measure – for example the Consumer Price Index – with the two most volatile components, food and energy, removed.
The wider public sometimes sees the use of a measure with food and energy removed as a sham, with the argument being that this ignores real costs that real people have to deal with. This misses the point. No one is claiming that the core inflation measure is the only relevant one, merely that it better represents the long-term trend. The graph shows that over 10 years, the total change in the full CPI, and the CPI with food and energy removed, is nearly the same.
US CPI OER background (4 Jan 2010) The Owner's equivalent rent (OER) component of CPI is an estimate of the inflation an owner would see in rent, if s/he were renting.
Cost of shelter is a major component of CPI, and it needs to be measured for homeowners as well as for renters. House prices are partly speculative and do not provide a good measurement of the cost of shelter alone. Hence the BLS was motivated to define the OER as, “the amount a homeowner would pay to rent, or would earn from renting, his or her home in a competitive market,” and to estimate inflation of OER.
In short, the BLS estimates inﬂation in the OER using inﬂation in market rents of nearby rental units; nearby, because their research indicates that changes in cost of shelter depends primarily on location. In a little more detail:
Spring 2006. International Productivity Monitor.
“The Boskin Commission Report: A Retrospective One Decade Later. Robert J. Gordon1”