Thursday, August 21, 2008

Does Inflation from the Old vs. New CPI Matter? NO

Some of the recent CD discussion has focused on the possible difficulties of comparing today's inflation rates to the inflationary 1970s period because of the changes that have been made to the way the BLS calculates the CPI. There was also some discussion about the timing of the changes to the CPI. Thanks to CD reader Spencer for the suggestion to check the BLS website for a comparison of the CPI-U-RS series (new) vs. the CPI-U series (old).

I was able to locate the BLS study "Consumer Price Index Research Series: Using Current Methods, 1978-1998," which finds that "the measured rate of inflation would have been lower since 1978 if methods currently used in calculating the Consumer Price Index for All Urban Consumers had been in place from that year to the present."

In other words, the old BLS method of calculating the CPI-U overstated inflation (which has been taught in Principles of Macro for decades), and various adjustments (14 in all, see Exhibit 1 in the study) made between 1983 ("changed homeowners’ component from cost of purchase to to value of rental services) and 1999 (the last 5 in 1998-1999 were maybe in response to the 1996
Boskin Commission Report?) attempted to make the CPI/inflation more accurate.

How big were the changes between the old CPI-U and the new CPI-U-RS after the 14 changes? Table 2 above tells the story:

1. Although most changes to the CPI lowered inflation rates under the revisions, some of the changes to the CPI actually increased inflation rates (see the row above titled "Effects of all other changes" that adjusted for the fact that the old series "understated" inflation in some ways).

2. Although the net effects in each period above were negative, meaning that inflation was overstated under the old methodology, the differences in inflation rates were relatively minor. For example, inflation from 1978 to 1982 averaged 9.46% annually under the old method and 8.46% under the new method, suggesting that the old method overstated inflation by about 1% per year.

For the other periods, the annual differences between old and new CPI inflation were relatively lower: -0.13% from 1983-1986; -0.35% from 1987-1997; and -0.23% in 1998, or an average of about 1/4 of 1% per year!

Bottom Line: With reasonable accuracy, we can fairly compare today's inflation rates calculated from the CPI-U-RS used by the BLS today to the inflation rates of the 1970s that used the old CPI-U, with a possible difference annually of only about 1% at the most. In other words, if you subtract 1% from the double-digit 10-14% annual core inflation in the mid- and late-1970s, you still get inflation way, way higher than the 1.5%-2.5% range of core inflation over the last ten years.

My position remains that unless, and until, we have core inflation approaching double-digits, inflation is not a problem. And I don't think there is near enough of a difference between the old CPI-U and the new CPI-U-RS to have that issue make any significant contribution to the inflation discussion.


At 8/21/2008 4:12 PM, Blogger spencer said...

I was in error on home owners equivalent rent being a product of the Boskin commission. It was implemented earlier.

But the other point is that you were using the PCE deflator and it has not been revised so the changes in the CPI do not impact it.

At 8/21/2008 6:26 PM, Blogger the buggy professor said...


You're referring, of course, to Mark's earlier posted article and chart, not the current one.


That said, I fear you're only partly right, and probably (just a guess, mind you) more wrong than fully right.

Specifically, the PCE deflator (which is chain-linked, unlike the CPI) may not have undergone all the technical changes urged by the Boskin Commision that the CPI indexes have --- but the core ones have been incorporated by the BLS

The evidence?

Well here, for instance --- in a very good survey of the Boskin Commission's proposed changes and adopted by the BLS --- one of the Commission's members, Robert Gordon of Northwestern, says this:

"An important piece of evidence on the nature of CPI bias comes from the longstanding
excess of the annual growth rate of the CPI over the PCE deflator. Any such excess is notable,
because the PCE deflator uses the same underlying micro price indexes as the CPI but weights them
differently. As discussed above, the CPI-U grew 0.38 percent faster than the PCE deflator during
1999:Q4 to 2005:Q4, a period when most of the improvements in the CPI were already in effect.
Over the period more relevant to the Boskin Commission bias estimates, 1992-98, the CPI-U grew
0.63 percent faster than the PCE deflator. This 1992-98 difference, which can be explained only by
The Boskin Report: A Retrospective One Decade Later, Page 28
item and category substitution effects (because the PCE has the same exact treatment of outlet substitution, quality change, and new product effects), provides prima facie evidence that the Boskin bias estimate may have been understated.
pp. 27-28


Still, there is a gap between the extent to which the chained PCE- and the chained CPI-deflators and the standard CPI measure price rises. But that is largely, as Menzie Chin says in her Aug 21st survey of various consumer price indexes because the quasi-Laspeyres nature of the CPI "systematically overstates" inflation in the period examined . . . which means it examines base-year prices (say 2006) but current 2008 quantities that the same income could buy.

By contrast, a Paasche looks at the same bundle of goods as the Laspeyres, but examines price inflation in current quantities and current (2008) prices.

See Menzie Chin:


In the end, I'll be honest about my own state of mind when I examine these technical matters. Experts have been debating the pros and cons for decades now, not just since the Boskin commission, and I doubt whether the debate will ever be settled.

Two points follow.

The Fed needs some technical measure --- core inflation --- to decide whether changes in the money supply and hence interest rates should be made (up or down). Mark's very informative posts about inflationary trends and the correlation between overall price inflation and various measures of money (itself a tangle of controversies!) are illuminating here.

But, secondly, core inflation is not what the average consumer or worker is going to be worried about when there are sudden surges in both volatility and especially upward movements in key household budget items like energy and food.

Beyond that, I doubt whether the technical debates will ever be settled, let alone convince consumers and workers to adopt this or that technical view.


Michael Gordon, AKA, the buggy professor


At 8/22/2008 1:46 AM, Blogger juandos said...

Thanks for posting this Professor Mark...

Much appreciated...


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