replace previous prices.

2 A resulting index of Chart 1 Relative Importance of Various Table 1 Twelve-month CPI Percent Changes Using Experimental
Product Groupings in the CPI, Home-ownership Components
150, for example, simply means that the
December 1979
current basket is 50 percent more expensive
The Consumer Price Index: than in 1967.
Flow of services method Outlay method

Concepts, Construction, and Controversy Conceptual Limitations

Inherent to the construction of any price
Household furnishings
and operation
X1 X2
User cost
X3
User cost
X4
Outlay
X5
Outlay
8.3%
index are technical problems such as selecting Fuel and utilities Official Rental current average current average
by Michael F. Bryan All transportation
an appropriate base period from which to 6.5% CPI equivalence interest interest interest interest
18.6%
construct the consumer basket. The ideal Miscellaneous Home January 1980 13.9 11.2 13.9 12.7 13.1 11.7
base period would be one in which no price items 13.4
maintenance February 1980 14.1 11.6 14.3 13.1 12.1
changes were occurring; hence, the consumer 4.1% 3.6%
Apparel and March 1980 14.7 12.0 15.5 14.1 13.9 12.5
The Consumer Price Index (CPI) is com- inherent problems that have prompted the basket would be assumed to be in equilibri- upkeep April 1980 14.7 11.7 15.7 14.2 13.8 12.3
um (or constant). Because such a period is Financinq taxes 14.4 15.4 11.9
monly referred to as "the rate of inflation" controversy surrounding its use in measuring 5.1% All food
and in;u rance May 1980 11.4 13.9 13.5
or as "the cost of living in the United States." inflation, particularly during periods of virtually nonexistent, analysts are limited to 18.7%
10.9% June 1980 14.3 11.1 15.6 13.7 13.4 11.5
The Consumer Price Index is not, however, rapidly changing prices. approximating the ideal. Other problems in- Entertainment Rent SOURCE: Bureau of Labor Statistics.
volve determining the frequency of purchase, 3.7% 5.3%
nor was it ever intended to be, either a defini-
tive or an ideal measure of cost-of-living The CPI: What It Is (or What It Isn't) especially for durable goods, and adjusting period.J Generally, any change in the price service, but they are paying for it in a differ-
changes in the United States. Indeed, as a Between 1972 and 1973, the Bureau of for changes in quality. Added to these are of one good or service will result in substitu- ent manner. Where the laundromat user pays
practical matter, such an ideal measure is the Census conducted a Consumer Expendi- the questions of "who" should be surveyed tion among competing goods and lead to for each individual laundering, the machine
probably impossible to construct. By its ture Survey covering 40,000 families living for current price information, and how often change in the quantities of those goods in purchaser pays for the entirety of services at
broadest definition, the CPI is a price guide in 216 urban areas of the United States. The the price surveys should be conducted. the consumer basket. The CPI, as a fixed- the time of purchase. Because the CPI does
for goods and services purchased by families detailed survey data of consumer-expenditure Beyond the technical concerns, though, weight index, does not incorporate these not distinguish between purchasing and con-
living in the urban centers of the United patterns were used to construct a "represen- are difficulties resulting from a "fixed-basket" changes on a regular basis.s suming, an increase in the purchase price of
States. More specifically, it is a price index tative" basket of goods and services purchased composition. To begin With, the basket for Similar adjustments in energy consump- a durable good is absorbed entirely by the
for a "fixed basket" of goods and services by "typical" consumers in each metropolitan the average urban family, even in 1972, did tion have clearly occurred. Sharp increases in CPI consumer pocketbook at the time of pur-
generally purchased by moderate-income region. The regional baskets were weighed not represent persons who were not part of the relative price of energy have forced con- chase, rather than distributed over the useful
urban families and single persons during with respect to the relative size of the various the "average" family or who did not live in sumers to be more energy conscious, result- life of the durable good.
1972-73. To imply that the CPI is a measure metropolitan areas and finally aggregated to an urban community. Survey data, for ex- ing in curbed consumption of products such The treatment of durable goods in the
of price changes for all goods or for all con- produce a national average market basket. ample, indicate that elderly consumers spend as gasoline. In this respect, the construction consumer basket is even more complex once
sumers exaggerates the value of the index as The 1972-73 consumer-expenditure patterns a greater percentage of their income on food of the CPI increases the impact of energy we introduce the investment aspect of dura-
an inflation barometer. were first introduced into the CPI in 1978, and medical care and less on transportation costs on the average urban family. ble goods. While all durable goods provide a
Despite its limitations as a cost-of-living updating the previously used 1960-61 spend- and entertainment than average consumers. changes for consumers other than the average service, many serve an investment function
indicator, the CPI remains the most popular ing patterns. The CPI basket, therefore, re- Persons living in rural areas probably spend urban family can be misleading. The Durable-goods Dilemma in that they are held, in some part, as an asset
and widely accepted measure of inflation in presents the consumption of an average urban relatively more on transportation and less on Perhaps most important of all, CPI con- The treatment of durable-goods prices that will be sold in the future. In this respect,
the domestic economy. Constructed by the family in 1972 (but not an individual family food and housing than urban residents. Using struction presumes that the basket of items is especially troublesome for any price index. an increase in the cost of a durable good in-
Bureau of Labor Statistics (BLS), the CPI or group of families in particularl.! the CPI to assess individual cost-of-living consumed does not change from that which An ideal measure of the current cost of living creases the value of the durable good "asset"
has been a timely and reliable price statistic Once constructed, the basket and indi- 2. The theoretical construction of the CPI was consumed during the "base period" (in must distinguish between purchasing and held by current owners. Nowhere is the dis-
for over 60 years. In the past decade, it has vidual items were priced and standardized to approximates the summation this instance, 1972-73). In actuality, how- consuming. When consumers purchase a tinction between purchasing, consuming, and
come into extensive use in collective-bargain- the value of 100 for the year 1967. Current ever, patterns of consumption do change over washing machine, for example, they are in investing more difficult than in the housing
ing agreements and in the current indexing index values are obtained by a monthly (in time because of changes in tastes, incomes, effect purchasing the regular clothes washing component of the index,where home owners
x 100, frequently purchase not only for shelter, but
of social-security benefits. Consequently, the some areas, bimonthly) survey of consumer- and relative prices. During periods of chang- service that the machine provides over its
CPI ranks among the most influential eco- goods prices in 85 standard metropolitan r.P~7 0;2 ing prices, consumers attempt to substitute lifetime. Consumers who choose to launder also for investment that later will yield a re-
nomic statistics published; unfortunately, it statistical areas (SMSAs). These prices then where less expensive items for more expensive at a laundromat also are purchasing laundry turn. Under current CPI construction, an up-
is often misused. This Economic Commen- items; therefore, changes in the CPI tend to ward movement in home prices only increases
pi = current prices of item i,
tary examines the construction of the Con- c overstate changes in the average cost of liv- 3. See U.S. Department of Agriculture, Economic the measured cost of housing.
1. Actually, the B LS constructs two baskets based
sumer Price Index and explores some of the on the 1972-73 CES study. The index for oi = weight (or composition) of item i in ing. If the price of beef, for example, in-
Statistic and Cooperative Service, Livestock Most of the controversy currently sur-
and Meat Situation, LMS 236, forthcoming in
urban wage and clerical workers (CPI-W) in- 72 basket according to 1972 consumer creases relative to other foods, consumers rounding the CPI concerns the manner in
August 1980.
cludes only employed wage and clerical survey, will purchase more pork or tuna fish and less which interest rates are incorporated in the
workers. The index for all urban consumers P~7= price of item i in 1967, 4. The CPI consumption basket is revised with
Michael F. Bryan is a research assistant, Federal beef. This is, in fact, a good example of the each major Consumer Expenditure Survey home-ownership component of the index.
(CPI-U) encompasses a broader group of con-
Reserve Bank of Cleveland. The author wishes
sumers, including salaried workers, retirees,
r. = summation of items, i,l ..•n, where behavior of the American consumer over the approximately every 10 years. An "ongoing" This component includes the purchase price,
to thank John J. Erceg and Mark S. Sniderman n is number of items in basket. CES analysis has been initiated by the Bureau
and unemployed persons, as well as wage and past five years. The 1980 per-capita con- financing, insurance, and maintenance of a
for their valuable assistance. For a complete description of the technical of the Census. It should also be noted that if
clerical workers. The CPI-U covers approxi- sumption of beef in the United States is home and accounts for almost 25 percent of
construction of the CPI, see William H. Wallace CPI revisions occurred too frequently, changes
The opinions stated herein are those of the mately 80 percent of the noninstitutional ci- expected to be almost 20 percent less than the CPI basket (see chart 1). Thus, cost
author and not necessarily. those of the Federal vilian population, while the CPI-W covers 40 and William E. Cullison, Measuring Price in spending patterns due to transient factors
Changes: A Study of Price Indexes, 4th ed. in 1976, while the per-capita consumption of enter the index, thus distorting a normal con- changes in these items have pronounced ef-
Reserve Bank of Cleveland or of the Board of Gov- percent. All data reported in this Economic
ernors of the Federal ReserveSystem. Commentary refer to the CPI-U. (Federal Reserve Bank of Richmond, 1970). pork has grown 27.5 percent over the same sumption basket. fects on the overall CPI in comparison with
 July 28, 1980

other individual items in the index. During Chart 2 Performance of the CPI
Table 2 Selected Personal Consumption Expenditure Shares, percent
periods of rapidly rising interest rates, as in and PCE Deflator
the early months of 1980, consumers sharply Percent cha 1972 1974 1976 1978 1980 CPI 1979
reduce their purchases of housing. Yet the 10 10 10 10 10 December
fixed CPI basket weighs housing purchases
according to the 1972-73 survey. 4.0 Gasoline and motor oil 3.4 3.0 3.1 3.1 2.7 5.6
0.7 0.5 1.2a

ECONOMIC
In response to this problem, the Bureau Fuel oil and coal 0.8 0.7 0.7
of Labor Statistics has developed five experi-
mental measures, built around alternative a. Includes bottled gas.
assumptions of the consumer cost of housing 3.0
(see table 1). The first three measures, called of rental homes. The sample of rental homes basket becomes less comparable to the CPI's
"flow of services" measures, attempt to cap- must display similar characteristics to those fixed basket in periods of changing prices.

COMMENTARY
ture the concept of housing as the shelter of purchased homes, such as size and location, The weight of energy in the consumer basket,
that a home provides. All consumers are in- 2.0 for accurate reflection of changes in cost. for example, has changed considerably since
cluded in the weighing scheme, since all con- Even the changing composition of the 1972, as consumers increasingly conserve on
sumers require some sort of shelter. "Outlay consumer basket in the PCE deflator has lim- expensive petroleum products (see table 2).
measurements," however, assume the cost of itations when assessing changes in the average
housing is determined by the amount spent, 1.0 cost of living. As substitution between con- Summary
or outlays, by consumers during the base sumer goods and services occurs, the deflator The fixed-basket CPI is a timely, infor-
period. Only those consumers who contracted will tend to understate the rate of change in mative statistic for measuring price changes of
for a mortgage payment in the base period 1972 1974 1976 1978 1980 fixed-basket consumer prices; consumer sac- a fixed basket of goods and services. How
are included in the weighing procedure. Some
of the experimental measures use current in-
the items in the consumer basket, therefore,
rifices incorporated
flator basket
into the implicit PCE de-
underestimate conclusions
accurately this basket typifies a specific con-
sumer depends on differences in consumption In this issue:
are "implicitly" weighed according to current
The Consumer Price Index:
terest rates, while others use a 15-year moving about cost-of-living changes. Moreover, be- patterns of groups and individuals in the
consumption patternsf Moreover, this mea- population. In periods of rapidly changing
average of interest rates to reflect the age dis- cause goods and services in the PCE deflator
sure excludes new home purchases, using a
tribution of mortgage debt outstandinq.f prices, the pattern of consumption changes,
Concepts, Construction, and
rental-equivalence approximation of housing change in every period, comparing indexes
Over the 12-month period ending in April for periods other than the base period is mis- and, at times, the fixed 1972 basket will not
costs-in other words, the cost associated with accurately represent the consumption pattern
1980, the rate of change in consumer prices leading to those who assume that index
Controversy
the rent that a home owner would have been even of the average urban family. Technical
using the alternative housing methods varied changes result purely from changes in price.
charged had he rented rather than purchased. problems, such as the effect of sharply chang-
from 15.7 percent (X2) to 11.7 percent (X 1). Index changes between periods contain
The PCE deflator also has some technical ing interest rates, add to the doubt that the
In other words, the assumptions chosen to changes in price and changes in composition
problems. Perhaps the most practical limita- CPI accurately captures cost-of-livinq changes.
measure the cost of housing materially affect of the basket.7
tion of the deflator is that initial monthly Although the PCE deflator is a useful
rates of change of the CPl. Behavior of the CPI and the PCE deflator
estimates are quite tentative and subject to supplement to the CPI, especially during pe- Federal Reserve Bank of Cleveland BULK RATE
can vary widely over short periods of time,
considerable revision for at least four months. riods of change, it also has limitations. The Research Department U.S. Postage Paid
The Implicit peE Deflator although over more lengthy periods the dif-
It is therefore a less timely measure of infla- PCE deflator is less timely. The accuracy of P.O. Box 6387 Cleveland,OH
Problems inherent in the fixed-basket ferences are much less pronounced (see chart
tion. Furthermore, although the rental equiv- the rental-equivalence method for measuring Cleveland, OH 44101 Permit No. 385
construction of the CPI can be resolved in 2). For the most part, the two price measures
alence method is probably more accurate in housing costs is also questionable, even
some part by the use of the implicit personal moved reasonably parallel between 1972 and
periods of changing interest rates, it is accu- though it is not subject to the direct effects
consumption expenditure (PCE) deflator. 1976. After 1976, the two indexes behaved
rate only to the point that the stock of pur- of sharply changing interest rates. As a cost-
Constructed by the Department of Com- less harmoniously; since early 1978 the rate
chased homes can be equated with a sample of-living guide, the PCE deflator does not
merce, the PCE deflator allows changes in of change in the CPI has been well above that
6. The theoretical construction of the PC E impl icit of the PCE deflator. Most of the current de- account for the sacrifices that the average
consumption patterns to be reflected in
price deflator approximates the summation viation stems from definitional differences in consumer makes in his consumption basket
weighting shifts from one period to another.
the treatment of the home-ownership costs as he substitutes less expensive alternatives
The index is derived by adjusting current f.piOi
c c and the effect of rising interest rates on the for goods he would have purchased.
consumer expenditures by corresponding x 100, Experience prior to 1978 suggests that
price indexes (primarily the CPI) and then ~pl
£.1 72
a!C
CPI. Further, the implicit PCE consumer
these two measures of consumer prices will
dividing nominal personal consumption ex- 7. The Department of Commerce constructs a behave more consistently as the rate of
penditures by the adjusted consumer expen- "chain price index" that weighs the composi-
current prices of item i, tion of output in the prior period and, there-
change in prices slows and the effect of in-
ditures. The separate price indexes that span
weight of item i according to cur- fore, reflects the change in prices between terest rates on the CPI weakens. It is impor-
5. The purpose of the experimental home-own- rent personal consumption expendi- two periods. This index, however, is limited tant, however, to recognize that the process
ership measures is to provide CPI users with a tures, to price changes between two consecutive pe- of measuring cost-of-living changes is difficult.

P;2
range of housing cost possibilities. For a more riods. A "fixed basket" PCE deflator is also
Limitations in the data and problems inher-
thorough description of the measures and their price of item i in 1972, constructed, although, fundamentally, it is
subject to similar criticism to the CPI in terms ent in the construction of price indexes in-
impact on the CPI, see U.S. Department of
Labor, Bureau of Labor Statistics, CPllssues, r. summation of items i, 1- n, where n of composition-related overstatements in sure that any price statistic will fall short as
Report 593, February 1980. is number of items in PCE accounts. prices. an absolute measure of inflation.