CPI vs Deflator

Dec. 24th, 2012

No, this is not an article about Mexican boxers or Japanese monster movies.  At a time when families come together to celebrate the holidays, the fiscal debate in Washington continues.  One of the issues being discussed is a change in the annual cost of living adjustments made to Social Security (SS) recipients.    Currently, SS payments are adjusted upwards by the annual Consumer Price Index (CPI).  The Social Security Administration (SSA) uses the urban survey, or CPI-U, one of the two major variations of the index and represents the buying habits of 87% of the population.  Each month, the Bureau of Labor Statistics (BLS) surveys a “basket” of goods and services that the typical urban consumer would purchase.  These include food, housing, clothing, transportation, medical care, and education.  The categories are weighted, with housing and monthly utilities accounting for a little more than 40% of the index. (BLS Source)

The index is set to 100, or think of it as $100, as of the period 1982-84.  What the index means is that it now takes $227 to buy what we could buy for a $100 in 1982.

The fiscal year for the Federal Government ends on Sept. 30th of each year.  The SSA uses the CPI for the previous twelve months ending in September to determine the cost of living adjustment for SS recipients.  Over the period of many decades, the rise in the CPI may look uniform but the annual change is fairly erratic.

Do consumers adjust their purchasing as erratically as the CPI changes?  No.  Household incomes don’t vary that much. The contention is that consumers make purchasing adjustments in response to changing prices.  If gasoline prices rise, a family may cut back their travel where they can.  If they can’t cut back in that area, they will cut back in another area, like dining out. If the cost of a strip steak rises over several months, a family may buy a cheaper cut of meat, or buy more chicken or pork.  This process of dynamic substitution on a monthly or quarterly basis is not accounted for by the CPI, which makes adjustments to their market basket much less frequently.

In response to this weakness in the CPI calculation, a measurement tool called the Implicit Price Deflator was invented.

The deflator makes substitutions in response to price rises.  Because the response of the deflator index is more dynamic, it changes less erratically than the CPI.

The deflator also considers utility, a concept which is both a strength and a weakness.  If a basic desktop computer in 2012 costs the same as one in 2006, but has twice the power and disk storage, the deflator will treat that component of its index as though it had fallen by 50%.  The argument, and a valid one at that, is made that someone who needs a basic desktop computer is going to spend the same amount of money and that the index should remain unchanged during that period.  The counter argument is that, since the consumer is getting more bang for the buck, she will need to spend less money on upgrades to that computer.

So, the debate is: 
The CPI overstates the effect of inflation
                            Vs
The Deflator understates the effect of inflation.

The annualized growth of the CPI since 1947 is 3.67%.  In that time, the Deflator index has risen at an annual rate of 3.35% (Source).  Think about that, girls and boys.  The “great debate” over Social Security is over 3/10ths of 1% annually.  That is $3 on a Social Security check of $1000.

Nancy Pelosi, the Democratic Minority Leader in the House, has said that any attempt to base the cost of living adjustment on the deflator rather than the current CPI index is to “destroy” the retirement security of millions of Americans.  Hyperbole is not partisan, however.  John Boehner, the Republican Majority Leader in the House, has said that using the deflator will “save” Social Security.  Armageddon rhetoric over 3/10th of 1%.  No wonder there is a lot of dissension in the halls of Congress.  The real cause of global warming is the amount of hot air blowing from Washington.

It is true that over the course of thirty years, 3/10th of 1% adds up to a 9.4% difference in the growth of Social Security checks, but we are talking thirty years.  Some argue that the difference between the two indexes has grown during the past thirty years.  For this more recent period, the difference is 45/100ths of 1%, or a total difference of 14.4% over the next thirty years.

Although the percentages in the debate over cost of living adjustments are small, the SSA sends out hundreds of billions of dollars annually to recipients.  The tiny difference in the cost of living adjustment is slight to each recipient.  To the Federal Government however, the savings are in the billions of dollars and that is what the argument is really about.  One party would like to take $3 out of one taxpayer’s pocket in higher taxes and put it in the pocket of a person receiving Social Security.  The other party wants to not give the person on Social Security the $3.

Two normal people having a debate about this might reasonably say “Hey, let’s split the difference.”  We could write a law that said that cost of living adjustments would be the average of the CPI and the deflator index.  But these leaders in Congress, and I will include the White House as well, are not normal people.  They might have been normal at one time but they have lost touch with the day to day reality of compromise that constitutes most of our lives.  They have become so consumed with their own importance, with the sanctity of their principles and their positions, that they find rational compromise all but impossible.

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