If you're like me, you do a double take every month when the government publishes its Consumer Price Index (CPI). Why? Because the government's main measure of inflation seems out of touch with reality.

In November, for instance, the headline from the Bureau of Labor Statistics (BLS) said that the CPI was up just 3.2% over the course of the past year. I don't know about you, but when I go to the store (or the gas pump!), it sure feels like I'm paying a heckuva lot more than that!

It's not just me, either: In a recent survey called the "Well-Being Index," The Principal Financial Group found that working folks are seeing "dramatic price inflation on daily consumer goods.'

And bond guru Bill Gross—the man who holds the purse strings for the largest bond fund in the world at Pimco—picked up on the theme in his October market commentary, saying: "The CPI as calculated may not be a conspiracy, but it's definitely a con job foisted on an unwitting public ...'

A con job? Dramatic price inflation? What's going on?

Being an index guy, I decided to take a look under the hood of this mysterious index to find out. What I discovered—both about how the index is calculated, and more importantly, how it is used—will shock you.

Shopping Bureaucrats

To understand what's going on with the CPI, you first have to understand what it is and how it's created.

The CPI, in the words of the government, is "a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services."¹ In other words, it's a measure of the inflation we experience in our day-to-day purchases.

To measure this change, the government employs teams of mystery shoppers, called "economic assistants," who travel the country tracking the price of a staggering 80,000-plus items. From coffee to apples to refrigerators to cars to nights spent in the hospital, if you can pay for it, the BLS is probably measuring it. And they don't just measure it at one store, either: They measure it at hundreds and thousands of stores in 87 different metropolitan areas, each and every month. They even try to go to different types of stores—say, Wal-Mart vs. convenience stores—in the same ratio that you and I do. The sheer volume of labor is mind-boggling.

What's Included?

One big challenge for the BLS is deciding what to include on the shopping list. Even with 80,000 items, you still have to make some choices. Hershey's or Snickers? Budweiser or Sam Adams? Is satellite radio popular enough to count?

To answer these questions, and to decide how to weight each item, the BLS surveys American consumers once every ten years, asking them about their shopping habits. There are mechanisms to add new products to the index during intervening years, but the majority of changes take place at the decennial survey.

While it's impossible to list everything that's included in the CPI (although I pull out a few items and their official "average" prices at the end of this article), you can look at the general categories that the CPI covers, and their relative weight in the index.



To the extent that your budget strays from this list, the BLS would tell you that you're out of whack with the average American consumer.

Why the CPI Matters

Why, you ask, does the BLS go through all this trouble? Simple: Because the CPI is the single most important index in the world. No matter who you are, this index has a direct impact on the wages you earn, the taxes you pay and the benefits you receive.



Here's why: Each year, the government uses the CPI to make cost-of-living adjustments (COLA) to Social Security, military and federal pensions and food stamps. They also use it to fine-tune the cost of school lunches, to determine the yield on inflation-protected bonds (TIPS), and since 1985, to adjust the federal income tax structure to prevent inflationary tax bracket creep.

A few percent a year may not seem like much, but when you compound it year after year and apply it to programs covering hundreds of billions of dollars in spending, it really adds up. That goes double for the federal government: With all those programs tied to the CPI, CPI-related adjustments alone amount to one of the larger items in the federal budget.

Despite the fact that the CPI is used to make cost-of-living adjustments, the government insists that it is not actually a cost-of-living index. It says so right on the BLS Web site: "[T]he CPI is not really a cost of living index ..."

The reason the government thinks that the CPI is not a cost-of-living index is that it does not include things like taxes, or the cost of maintaining a certain level of security or environmental quality. They're right about that. The problem is, they're currently taking steps that will make the CPI a less accurate measure of the cost of living, rather than a more accurate one. And they're doing it in a way that will compound the error for years to come.

The Boskin Commission And The Hoodwink Of Hedonic Regression

Back in the mid-1990s, with the budget deficit a hot topic on the political trail, the Senate Finance Committee appointed a special commission to study the CPI. This commission, known as the Boskin Commission, looked at a full run of factors and decided that the CPI overstated inflation by about 1.1%/ year.

Surprised? You shouldn't be. In its report to Congress, the Boskin Commission noted that eliminating just half of this bias would shave more than 10% off the federal budget deficit by the year 2000. Imagine the windfall to politicians: Eliminate a good chunk of the deficit by "fixing" bad numbers. It was too good to be true.

Not surprisingly, the BLS enacted a suite of reforms as a result of the Boskin Commission, which they estimate have cut about 0.5%/year off of the CPI.

To be fair, many of these reforms make sense. For instance, the BLS began to account for what's called "substitution bias," or the tendency for consumers to substitute one product for another if the cost of one product rises. We all do that: I love strawberries, but if they cost more than $1.99 a pound, I buy apples instead.

But one of the reforms enacted by the BLS strikes me as just plain wrong: The move to correct for "quality bias," or the tendency of the CPI to overstate inflation by not taking into account the improving quality of a product.

Like substitution bias, the idea of quality bias makes sense. Many of the products we use each day are getting better: cell phones get smaller each year, TVs today have better pictures than when I was a kid, cars are safer, etc. To the BLS bureaucrats, paying more to get more doesn't represent inflation. It represents choice. The BLS even has a very complicated statistical technique with a fantastic name—"hedonic regression"—to determine how much of a product's increase in price is related to quality and how much is related to inflation.²

The problem, of course, is that these hedonic adjustments have nothing to do with what it actually costs to live. It's true that the cell phone I have today is much better than the clunky one I carried around back in 1998, but I still shelled out the same $200 at Radio Shack when I bought it. You can't take hedonic adjustments to the bank, and you certainly can't use them to pay the mortgage.

The BLS started using these "hedonic adjustments" back in 1998, and they chose a good test item: computers. Computers, as we all know, get much more powerful each and every year. The $2,000 computer you bought in 1997 couldn't hold a candle to a $2,000 computer purchased at Dell.com today. Still, if you need a computer, the price is similar: All told, the real price of computers has declined by about 8% a year for the past decade.³ But using hedonic regression, the BLS will tell you that the "adjusted price" of computers has dropped 25% per year since 1997. Whammo presto, lower inflation.

The adjustment to computers proved so popular with politicians that the BLS started doing it with everything: cable TV service, washer/dryers, refrigerators, even college textbooks. At least one-third of the CPI is now subject to hedonic adjustments. Some of the adjustments seem almost comical: For instance, although the price of basic cable service has gone up, the "hedonically adjusted price" has gone down, because basic packages are offering more channels. What's that old Bruce Springsteen song? 57 Channels (And Nothing On) …

The Concord Coalition put out a very cogent analysis of the problem with hedonic regression in its December 1996 analysis of the Boskin Commission:

A third problem is the economist's assumption that our social context remains forever fixed and that only the marketplace changes ... [T]his is absurd: Satisfaction depends on social norms. The same polyester suit your grandfather viewed with wonder you may view as a disposal challenge.
Indeed, so powerful are these norms that they often leave us with no choice but to buy goods and services that conform - even if it means doing without other things some of us might value more. Nineteen-fifties style health care is not only unavailable in the 1990s, it's illegal.⁴

Long-Term Impact

To be fair, there's a big question about the overall impact of these hedonic adjustments on today's CPI. In a persuasive riposte to Gross' argument, Bloomberg columnist John Berry pointed out that hedonic adjustments to the "rent" portion of the CPI—inflationary adjustments that reflect the aging of housing stock—essentially cancel out the impact of the other, deflationary hedonic adjustments. BLS economist Patrick Jackman told Barry that "the overall impact of hedonic adjustment on the rate of change in the CPI is "virtually zero."

Gross disagrees, arguing that the impact in the past year alone ran from 3% to 3.6%. It's hard to know whom to believe.

What worries me, however, is that hedonic adjustments by their very nature disassociate the CPI from what it actually costs to live. To date, there have only been a few years for the impact of this disassociation to take place, so the discrepancy is small. But even if the hedonic adjustments put only a small downward pressure on the CPI each year, with the power of compounding interest, that's sure to add up. I get the feeling that 39 years down the road when I start collecting Social Security, my tiny check won't buy me a cup of coffee.

Revisited Again? Watch For More Revisions As The Budget Deficit Swells

During the Presidential debates, I listened to both candidates claim that they would cut the budget deficit in half over the next four years. The moderator kept pressing them on this issue, but neither candidate would go into the details.

Through it all, the same thought kept circling through my mind: another Boskin Commission. The Concord Coalition says that the BLS has only corrected about half of the 1.1% error present in the CPI, and the BLS's own Web site agrees.

Here's a quote from the BLS's FAQ section on the CPI:

"It is generally believed that the CPI overstates inflation (the rate of change in the index itself). It is even likely to contribute to inflation in that things like union contracts and social security payments are tied to the CPI. BLS is aware of these shortcomings, and recently has undertaken efforts to correct some of them."

With the election settled and the budget deficit soaring, don't be surprised if you hear about another downward adjustment for the CPI soon.

Endnotes

1 Notice the word "urban.' As it turns out, the "CPI" is actually called the Consumer Price Index for All Urban Consumers (CPI-U). As the name suggests, the CPI-U ignores the spending patterns of people living in the country, as well as members of the Armed Forces. The fact that it's used to calculate the Social Security and pension benefits of the same people is curious, to say the least.

2 This makes for great reading. If you go to the BLS website, you can download 40-page treatises on the quality improvements of, say, clothes dryers. Did you know, for instance, that doors that swing down on dryers are more valuable than doors that swing sideways, because you can use the down door as a place to fold clothes? Your tax dollars funded a study to find that out!

3 Gross, Bill, "Haute Con Job," Investment Outlook, PIMCO Bonds Web site, October, 2004.

4 Concord Coalition, Facing Facts Alert #27. Co-authored by Neil Howe and Richard Jackson. Volume II, Number 15, December 24, 1996.