'In theory' I've checked all the links. If any are bad, let me know.
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 monetary 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 entitlement programs (e.g. Social Security, Disability). 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.
Under Nixon’s Federal Reserve chairman, Arthur Burns, the concept of “core inflation” was devised. Core inflation creates a separate CPI index that does not include the costs of food or energy. Core Inflation is used by the Federal Reserve to measure the effectiveness of monetary policy.
In addition to core inflation, there are several additional biases understating inflation that have been built into the CPI over time.
Through the introduction of hedonics, adjustments for quality change, the substitution effect, intervention analysis, owner’s rent equivalence, and geometric weighting, which are all soft metrics that are open to political manipulation and can be used to artificially lower inflation, the CPI has morphed from measuring inflation in relation to a set standard of living to measuring inflation in relation to a declining standard of living.
Owners Equivalent Rent was introduced under Reagan, lowering the cost of housing. Two CPI indexes, Owners’ equivalent rent of primary residence (OER) and Rent of primary residence (Rent), measure the change in the shelter cost consumers receive from their primary residences, not the actual cost owning your home.
Under Clinton the Greenspan/Boskin concepts of product substitution, geometric weighting, intervention analysis, and hedonic adjustment were introduced. 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’.
Over a period of several years, straight arithmetic weighting of the CPI components has shifted to a geometric weighting which gives a lower weighting to CPI components that are rising in price on the assumption that they are consumed in lower quantities, and a higher weighting to those items dropping in price. Weighting works in conjunction with the substitution effect, hedonics, and intervention analysis.
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.
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.
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’.
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.’
Another example of quality adjustment is found on the BLS web site. If your 27” CRT TV dies, a new 27” CRT is no longer available; the current equivalent is a 42” plasma TV. However the 42“ plasma TV includes more features that the 27 inch CRT. So the actual price you pay for the new TV is adjusted downward by –7.1%.
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.) Intervention Analysis is used to tones down severe upswings.
The C-CPI-U [CPI measured using chained dollars] was introduced during the GW Bush Administration as an alternate CPI measure. Unlike the theoretical approximation of geometric weighting to a variable, substitution-prone market basket, the C-CPI-U is a direct measure of the substitution effect.
The C-CPI-U uses a chained index which compares one quarter's price to the last quarter's instead of choosing a fixed base. This price index method assumes that the consumer has made allowances for changes in relative prices. That is to say, they have substituted from goods whose prices are rising to goods whose prices are stable or falling. Also in comparison to the headline United States Consumer Price Index, which uses one set of expenditure weights for several years, this index uses a Fisher Price Index, which uses expenditure data from both the current period and the preceding period.
Very simplistic example:
Q1 $100.00:
Q1 $101.00:
Q1 $102.00:
Q1 $103.00:
Using constant Q1 dollars the CPI increased 3% in Q4.
Using chained dollars, the C-CPI increased 1% in Q4.
Per Williams: “Changes estimated by the BLS show roughly a 4% understatement in current annual CPI inflation versus what would have been reported using the original methodology. Adding the roughly 3% lost to geometric weighting -- most of which not included in the BLS estimates -- takes the current total CPI understatement to roughly 7%.”
Based on detailed BLS estimates of the impact of its methodological changes over time, published in the Monthly Labor Review, June 1999 ("Consumer Price Index research series using current methods, 1978-98," by Kenneth J. Stewart and Stephen B. Reed), SGS has reworked the CPI-U series to remove the impact of the various methodological changes.
Graph 1
The first graph shows the level of the CPI with December 1977 = 100. The middle line is the official CPI-U. The bottom line is the version of the CPI-U published by Messrs Stewart and Reed that estimates what the historical CPI-U would look like if all present-day methodologies were carried back in time and the CPI were restated.