Why Is the Consumer Price Index Controversial?

The U.S. Bureau of Labor Statistics (BLS) produces the Consumer Price Index (CPI). The monthly publication of this number is the most widely watched and used measure of the nation's inflation rate.

From an investor's perspective, the CPI, as a proxy for inflation, is an important component used to estimate the total return on an investment or portfolio of investments.

Nevertheless, there has been debate for some years about whether the CPI overstates or understates inflation, how it is measured, and whether it is an appropriate proxy for inflation.  Economists do not agree on how inflation should be measured.

The Controversy Over CPI

Originally, the CPI was determined by comparing the price of a fixed basket of goods and services for two different periods. In this case, the CPI was a cost of goods index (COGI).

Over time, the U.S. Congress embraced the view that the CPI should reflect changes in the cost to maintain a constant standard of living. Consequently, the CPI has evolved into a cost of living index (COLI).

Changes in Methodology

Over the years, the methodology has undergone numerous revisions. According to the BLS, the changes removed biases that overstated the inflation rate.

The new methodology takes into account changes in the quality of goods and the effects of substitution. Substitution, the changes consumers make in response to price increases, also changes the relative weighting of the goods in the basket. The overall result tends to be a lower CPI.

Critics view the methodological changes and the switch from a COGI to a COLI as a purposeful manipulation that allows the U.S. government to report a lower CPI.

Opposing Views

John Williams, an American economist and analyst of government reporting, prefers an inflation measure that uses the original CPI methodology based on a basket of goods with fixed quantities and qualities.

David Ranson, another economist, also questions the official CPI's viability as an indicator of inflation. Ranson does not argue that the CPI is manipulated. Instead, he views the CPI as a lagging indicator of inflation and not a measure of current inflation.

Ranson believes that the prices of commodities are a better indicator of current inflation because inflation initially affects raw materials prices. It can take several years for the changes to work their way through an economy and to be reflected in the CPI. Ranson bases his inflation measure on a commodity basket of precious metals.

What is immediately apparent is that there are three different ways to define consumer inflation. Each method of measuring inflation leads to different results.

Different CPI or Inflation Levels

The different methods of measuring inflation produce different numbers for inflation for the same period.

Williams and Ranson conducted an academic study based on the November 2006 Consumer Price Index Summary, which was published by the BLS. The BLS stated: "During the first 11 months of 2006, the CPI-U rose at a 2.2% seasonally adjusted annual rate (SAAR)."

Williams' estimate of CPI for the same period was 5.3%, while Ranson's estimate was 8.2%.

If Williams and Ranson are correct, an investment plan based on the official CPI would be less than effective. Therefore, a prudent investor may wish to obtain more insight and a better understanding of these disparate views of CPI and inflation measures and the effects they may have on their investment decisions.

Inflation and Profit Calculations

The inflation rate impacts the results investors and analysts calculate when they determine the returns on a portfolio. Investors calculate their total required rate of return (RRR) on a nominal basis taking into account the effect of inflation. As the inflation rate increases, higher nominal returns must be earned to achieve the same real rate of return.

The nominal annual required total return is estimated by adding the rate of inflation to the real required return.

For short investment horizons, the approximate method works well. However, for longer investment horizons (such as 20 years or more), a slightly different method should be used to avoid compounding the effects of a minor inaccuracy.

A more accurate estimate of the nominal annual required total return is calculated as the product of one plus the annual inflation rate and one plus the required annual real rate of return.

The following table measures the three respective methods of inflation figures with a 3% desired rate of real return. The results in the table show that as the difference between the inflation rate and the real rate of return increases, the difference between the approximated and the accurately determined total required returns increases.

The effect of these differences is magnified as the investment horizon increases. The next table shows the effect on the value of $1 compounded for 10, 20, and 30 years at the various nominal total required returns determined for each inflation estimate. The first is the rate of return in each pair and is approximated; the second rate is more accurately determined.

Implications for the GDP

The GDP is one of many economic indicators investors can use to gauge the growth rate and strength of an economy.

The CPI plays a vital role in the determination of the real GDP. Therefore, manipulation of the CPI could imply manipulation of the GDP because the CPI is used to deflate some of the nominal GDP components for the effects of inflation.

CPI and GDP have an inverse relationship, so a lower CPI—and its inverse effect on GDP—could suggest to investors that the economy is stronger than it really is.

CPI and Government Spending

Many government expenses are based on the CPI and, therefore, an inaccurate CPI would have a significant effect on future government expenditures.

A lower CPI has at least two major effects:

1. Many government payments, such as Social Security and the returns from TIPS, are linked to the level of the CPI. A lower CPI translates into lower payments to citizens and lower government expenditures.
2. If the true rate of inflation is higher than the published CPI, an investor's real rate of return will be lower than originally expected as hidden inflation erodes gains.

Factors Adding to the Controversy

Many factors contributing to the CPI controversy are shrouded in the complexities of statistical methodology. Other major contributors to the controversy hinge on the definition of inflation and the fact that inflation must be measured by proxy.

The BLS describes the CPI as a measure of the average change in the price of goods and services purchased by households over time on an average day-to-day basis. The BLS uses a cost of living framework to guide its decisions regarding the statistical procedures used to determine the CPI. This framework means that the inflation rate indicated by the CPI reflects the changes in the cost of living or the cost of maintaining a fixed standard of living or quality of life.

In other words, it is a cost-of-living index. The procedures used by the BLS to calculate the CPI are presented in detail in the BLS Handbook of Methods, Chapter 17, titled "The Consumer Price Index."

CPI and Consumer Behavior: An Example

Consider this simplified example of the effect of the CPI on consumer behavior and the ways it can be calculated.

Suppose that the only consumer product available is beef. Only two cuts are available: filet mignon (FM) and T-bone steak (TS). When prices and consumption were last measured, only FM was purchased, and the price of TS was 10% less than the price of FM. When next measured, prices had increased by 10%. The scenario is presented in the table below.

The CPI, or inflation, for this contrived scenario is calculated as the increase in the cost of a constant quantity and quality of beef, or a fixed basket of goods. The inflation rate is 10%. This is essentially the way the CPI was originally calculated by the BLS, and it is the methodology used by Williams. This method is unaffected by whether consumers change their buying habits in response to a price increase.

The current BLS methodology of calculating CPI takes into account changes in consumer purchasing preferences. In this example, if there is no change in consumer behavior, the calculated CPI would be 10%. This result is identical to that obtained with the fixed basket method used by Williams. However, if consumers change their purchasing behavior and fully substitute TS for FM, the CPI will be 0%. If consumers reduce their purchases of FM by 50% and purchase TS instead, the BLS-calculated CPI will be 5%.

The previous calculations showed that the CPI methodology used by the BLS, given the scenario and consumer behaviors described above, results in a CPI that depends on consumer behavior. Furthermore, an inflation level that is lower than an observed price increase can be measured.

Although this example is contrived, similar effects in the real world are definitely within the realm of possibility.

The Bottom Line

The Consumer Price Index is a widely quoted monthly reading of changes in the cost of living for American consumers. It is the key measure of inflation used by policymakers and investors to make their decisions.

Yet it is, according to some economists, an imperfect reading. At least, it may underestimate inflation as it is experienced by some consumers some of the time.

Correction—April 3, 2024: This article has been edited to reflect that the CPI is able to capture shrinkflation accurately.