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CPI Revision to Mean Smaller COLA Increases

By John M. Berry
Washington Post Staff Writer
Friday, April 17, 1998; Page A01

The government's main inflation gauge will be changed to account for the fact that consumers respond to the rising prices of many items by shifting to lower-cost substitutes, the Bureau of Labor Statistics announced yesterday.

The announcement marked the end of a series of changes in the consumer price index that were begun in 1995 to correct for the CPI's tendency to overstate the actual rise in the cost of living. The changes affect the vast majority of Americans and the budgets of governments at all levels because the CPI is used to determine cost-of-living adjustments in benefits, such as Social Security, and for adjusting features of the income tax such as standard deductions and tax brackets.

When the change announced yesterday is incorporated into the CPI next January, the cumulative effect of all the revisions will be to trim the annual increase in the index by about eight-tenths of a percentage point.

The latest change, which will shave about two-tenths of a percentage point from the reported inflation rate, is designed to reflect shoppers' natural tendency to alter their purchasing patterns when the price of an item rises faster than an available substitute.

At a news conference, BLS officials cited the example of what typically happens when the price of a particular brand of ice cream goes up: Many consumers will either switch to another brand, buy a different-sized package, go to another store or switch to a close alternative, such as frozen yogurt.

The CPI now is based on changes in the cost of a fixed market basket of goods and services and assumes that consumers don't switch to a less expensive alternative when they have the opportunity. The new procedure for calculating the index is based both on economic theory and actual changes in consumer spending patterns in response to price changes as shown by checkout scanner data from supermarkets, BLS Commissioner Katharine G. Abraham said.

"The evidence we looked at suggested that consumers are sensitive to price changes," Abraham said.

The latest changes build on previous modifications in the CPI aimed at improving its accuracy in accounting for inflation. These include, among other things, updating the market basket to reflect more recent information about actual consumer spending patterns, improving the tracking of hospital charges, and measuring rents more accurately.

The changes have been implemented amid a heated debate in recent years about whether the CPI was overstating inflation. The BLS began researching problems with the index in the early 1990s. In late 1996, a commission headed by Michael Boskin of Stanford University concluded that the CPI was overstating the actual increase in the cost of living by more than a percentage point a year. Although many analysts challenged the commission's findings, economists broadly agree that there has been an upward bias in the CPI.

In effect, the changes mean that retirees whose benefits are linked to the CPI were routinely getting larger COLA's than those to which the rising cost of living entitled them. Similarly, taxpayers were paying less in taxes than would have been the case with a more accurate measure. Thus, the overstatement of inflation worsened the government's budget problems by increasing spending and reducing revenue.

The revisions in the index will improve the government's finances while causing benefits to rise more slowly than they otherwise would.

In January, an average retiree who last year had a monthly Social Security benefit of $749 got a cost-of-living increase of about $16 a month, or $192 a year. That was the result of a 2.1 percent rise in the CPI from the third quarter of 1996 to the third quarter of last year.

If the rise in the CPI over that period had been 2.4 percent, the likely figure had the BLS not begun changing its methods of calculating the CPI, the increase in the monthly benefit would have been about $19 instead of $16. For all of this year, that would have been $228 rather than the actual $192.

Over time the differences grow. Assuming the CPI rises at 2 percent annually for the next three years, for example, by 2001 monthly benefits would be about $20 less than if the CPI were calculated using the old procedures.

The change announced yesterday affects all but 15 of the 211 categories of goods and services in the CPI market basket. But the 15 items are so important that they account for almost 30 percent of the total index.

These include housing, most utilities and some government fees such as automobile registration charges. The BLS decided not to use the new technique for these because consumers don't have ready access to a substitute, at least not without making a major change in their lives by, say, moving to another location.

© Copyright 1998 The Washington Post Company

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