The CPI per the BLS is
“The Consumer Price Index (CPI) 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”.
Originally the CPI was designed to measure the cost of a fixed basket of goods, i.e. comparing apple to apples. The rationale behind this was to use a set standard to accurately measure return on investment in relation to inflation, and to accurately measure the standard of living one can afford on a given income in relation to inflation.
The CPI is important because it is used by the Federal Reserve to justify its money printing policies, to set the interest rate on inflation-adjusted bonds known as TIPS, and by the federal government to calculate cost-of-living adjustments (COLA) for the entitlement programs (e.g., Social Security). The more inflation is understated, the higher the inflation-adjusted rate of GDP growth that gets reported. In addition, the CPI influences interest rates, the stock market, and a host of salary and pension negotiations each year
In addition to separating out the cost of food and energy from core inflation, there are several biases understating inflation that have been built into the CPI.
Through the introduction of hedonics, adjustments for quality change, the substitution effect, and geometric weighting, which are soft metrics that are open to political manipulation and can be used to artificially lower inflation, the CPI has changed from measuring inflation in relation to a set standard of living to measuring inflation in relation to a declining standard of living.
In the early 1990’s the ‘substitution effect’ was introduced as a result of the
Boskin Report which deemed the fixed basket of goods was irrelevant. For example if the price of steak went up ‘too much’ the price of hamburger, chicken, or Spam was substituted. The CPI morphed from the cost of maintaining a certain standard of living to the cost of maintaining a declining standard of living.
Information about using substitution is found
here (Boskin Commission Report). The example used is chicken vs beef.
The actual steak vs hamburger is found
here (Panel Sees a Corrected Price Index as Deficit-Cutter). In the same article you'll see references to substitution and quality change.
Over a period of several years, straight arithmetic weighting of the CPI components was shifted to a geometric weighting which gives a lower weighting to CPI components that are rising in price, and a higher weighting to those items dropping in price. Weighting works in conjunction with the substitution effect, quality change, and intervention analysis.
Hedonics aka quality adjustment is my personal favorite. Hedonics adjusts the prices of goods for the increased pleasure the consumer derives from modifications or quality changes to those goods, e.g. if you pay more for gas because of federally mandated additives, the additional cost does not count toward the CPI because of your increased pleasure in breathing ‘cleaner air’.
A Hedonic Price Index for Airline Travel:
Re: Hedonics and Quality Adjustment - QUALITY ADJUSTMENT FOR GASOLINE
"A quality adjustment has been made to gasoline prices used in the January CPI to account for the effects of the mandated introduction of reformulated gasoline in selected areas of the United States. The gasoline index rose 0.4 percent in January, following seasonal adjustment. Without the quality adjustment, it is estimated that this index would have increased 1.1 percent. In those areas required to sell the reformulated gasoline, virtually all of the January price quotes were for reformulated gasoline."
From the
1999 Economic Report of the President: "… reason for the slowing of reported price indexes has been methodological changes to both the CPI and the indexes used in the national income accounts ".
”Intervention analysis seasonal adjustment allows economic phenomena that are not seasonal in nature, such as outliers and level shifts, to be factored out of indexes
before calculation of seasonal adjustment factors. (An outlier is an extreme value for a particular month. A level shift is a change or shift in the price level of a CPI series caused by an event, such as a sales tax increase or oil embargo, occurring over one or several months.)” is used to tones down severe upswings.