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The Unbiased Truth on Chained CPI and Social Security

When President Obama's budget proposal came out earlier this week, it included provisions to replace existing cost-of-living adjustments for Social Security with an alternative method using what's called the chained consumer price index. Immediately, politicians came out with wildly disparate characterizations of what impact switching to a chained CPI would have, most of which happened to coincide with their particular political views.

But rather than relying on biased opinions, you owe it to yourself to learn the facts. With that goal, here's a brief explanation of what chained CPI is and why it has led to such strong debate in Washington and across the nation.

The basics of chained CPI
To understand the chained CPI, you have to go to the group that calculates it: the Bureau of Labor Statistics. More than a decade ago, the BLS started calculating what it called the C-CPI-U, or Chained Consumer Price Index for All Urban Consumers. In 2003, a paper from three BLS economists (link opens PDF file) explained the new inflation benchmark in great detail.

The purpose of the chained CPI was to account for an economic phenomenon known as substitution bias. The regular CPI makes assumptions about the various mix of goods and services that a typical household spends money on, weighting the overall changes in prices for those goods and services by the proportion that households spend on each category. For instance, as of last December, the CPI assumed that the typical household had 41% of its spending go toward housing, 15% on food, and 17% on transportation, with further divisions by subcategory within each of those broad categories.

The BLS changes the regular CPI's category weights from time to time. But what the chained CPI does that the regular CPI doesn't is to take into account the fact that when prices of two different items that are fairly close substitutes for each other don't move in lockstep, consumers tend to buy more of the relatively cheaper good -- thereby making fixed category weights theoretically incorrect.

Is the substitution effect real?
The idea that people respond to price changes is a fundamental axiom of economics. Businesses rely on that effect to attract new customers. For instance, U.S. automakers Ford (NYSE: F  ) and General Motors (NYSE: GM  ) struggled throughout the early and mid-2000s, as Japanese rivals Toyota (NYSE: TM  ) and Honda (NYSE: HMC  ) built better-quality cars that more consumers wanted. In the hopes of retaining customers, Ford and GM offered substantial sales incentives, including rebates and low-interest financing. The result was that more people bought Ford and GM products than would have under stable prices. Now that Ford and GM's fortunes have reversed and gotten more positive, Japan's automakers are the ones considering ways to attract customers.

What's particularly challenging, though, is figuring out how people make substitutions. The paper notes the difference between substituting for items in the same subcategory -- say, a Ford for a Toyota -- versus substituting for items in different subcategories, such as taking the bus rather than buying a car or buying groceries rather than eating out. The need for more extensive data to determine appropriate adjustments led the BLS to use initial, interim, and final chained CPI calculations, with lags of up to two years for final results to become available.

The result of that much longer process is a more complete picture of how people respond to price changes. To the extent that the data reflect the inelastic demand for necessities -- such as the health care needs of Social Security recipients -- the chained CPI should reflect the fact that no substitution effect exists for goods and services for which there's no viable substitute.

Theory vs. practice
For the most part, those who criticize the chained CPI take issue not with its methodology but with its impact. Advocates on both sides of the issue of how much Social Security benefits should rise over time have reasonable policy arguments for their respective positions. But using the chained CPI as a scapegoat distracts the debate from its proper focus: whether the country can afford to allow entitlement spending to grow at its current pace indefinitely. Unfortunately, with the reluctance to address that issue head-on, the chained CPI will continue to get more attention than it arguably deserves.

Ford has been part of the substitution effect for years, but now, it's on the winning end of the equation. There's good reason to think that the Blue Oval still has big growth opportunities ahead, and we've outlined those opportunities in detail in the Fool's premium Ford research service. If you're looking for some freshly updated guidance to Ford's prospects in coming years, you've come to the right place -- click here to get started now.


Read/Post Comments (6) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 12, 2013, at 6:09 PM, OnTheContrary wrote:

    Seniors trying to live on fixed income Social Security payments are not typical urban consumers, and they have far less flexibility in making substitutions. Thus a shift to chained CPI disproportionately penalizes this poorest class of Americans (even welfare recipients make more). That' s the whole point of this exercise: to screw more money out of the poorest class of seniors.

    I say more, because as economist John Williams's ShadowStats website shows, real inflation has been running at 6-10% a year for decades, thus the paltry <2% COLA adjustments that are made to SS on the average cut Social Security payments in real terms by at least 4% a year. And that's probably an underestimate, because medical provider and insurance costs have been among the most rampant inflationary category during that period and seniors are disproportionately exposed to that. Of late the increased deductions for Medicare alone have largely wiped out the paltry COLA adjustment.

    Just to set the facts straight.

    If you think that there's an argument to be made for further screwing seniors when no one connected with government and Wall Street is suffering more than minor economic inconveniences from time to time, I would like to hear it.

  • Report this Comment On April 12, 2013, at 7:04 PM, lenglish2 wrote:

    I'd like to know who ever said entitlements would continue at their current pace "indefinitely", besides you I mean.

  • Report this Comment On April 13, 2013, at 3:51 PM, Easygoingtoo wrote:

    CPI should be calculated for those who are receiving SS based on the goods and service those on SS typically spend the majority of there income. They aren't buying houses but more likely medical care and prescription and over the counter drugs and other medical needs like dental care etc.

  • Report this Comment On April 13, 2013, at 6:11 PM, prginww wrote:

    "They aren't buying houses." The consumer price index, chained or not, doesn't include house prices. It has for decades priced rent and the imputed rent of owner occupied housing. The so called biases in the CPI due to fixed weights, or infrequently reweighted CPI, do cause over or understatements of the cost of living. I know a little about this since my first job as a newly minted econometrician was to study quality change and housing at the BLS some 46 years ago. The chain weighted CPI is long overdue.

  • Report this Comment On July 02, 2013, at 9:02 PM, rusureuwant2know wrote:

    The problem with the substitution method? Eventually it has people digging in dumpsters for their "substitutes" and they become irrelevant.

    Actually, giving it a new name (Chain CPI) doesn't make it any different than the method they've been using all along (substitution method or hedonics)

  • Report this Comment On July 02, 2013, at 9:03 PM, rusureuwant2know wrote:

    Btw, Social Security isn't an "entitlement".

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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