Why use different price indices?
There is broad consensus that the Consumer Price Index for all Urban Consumers (CPI-U) significantly overstates inflation because it does not accurately reflect the influence of new consumer products, changes in the quality of goods, or the shift to low-cost stores. Consequently, the official poverty thresholds, which are adjusted over time using the CPI-U have been rising faster than true inflation, which then masks the true progress that has been made in reducing poverty. More details on this bias and how we correct for it is available below.
Previous research has emphasized four types of bias in the CPI-U: substitution bias, outlet bias, quality bias, and new product bias. Substitution bias occurs when the index uses a fixed market basket and people substitute away from high-relative-price items. Outlet bias refers to inadequate accounting for the movement of purchases toward low-price discount or big-box stores. Quality bias refers to inadequate adjustments for quality improvements in products over time. New product bias refers to the omission or long delay in the incorporation of new products into the index. The report of the Boskin Commission (Advisory Commission to Study the Consumer Price Index 1996), a group of distinguished economists appointed by the Senate Finance Committee to study CPI bias, concluded that the annual bias in the CPI-U was 1.1 percentage points per year at the time of the report, but 1.3 percentage points before 1996.
Correcting for the Bias
The Bureau of Labor Statistics (BLS) has implemented several methodological improvements in calculating the CPI-U over the past 25 years (Johnson, Reed, and Stewart 2006). Although the BLS does not update the CPI-U retroactively, it does provide a consistent research series (CPI-U-RS) that incorporates many of the changes. However, the CPI-U-RS corrects for only about 0.4 percentage point on average of the 1.1- to 1.3-percentage-point annual bias in the CPI-U. Thus, our base price index, what we call the bias-corrected CPI-U-RS, subtracts 0.8 percentage point from the growth in the CPI-U-RS index each year from 1978 onward. Because the CPI-U-RS provides a consistent series only since 1978, we subtract the full 1.1 percentage points from changes in CPI-U inflation for earlier years. We also base this adjustment on Robert Gordon (2006), who argues that even with recent alterations to the CPI-U methodology that make it and the CPI-U-RS essentially the same for recent years, a bias of 0.8 percentage point per year remains. Ernst Berndt (2006) reports that the bias remaining in 2000, as estimated by each of the individual Boskin Commission members, ranged from 0.73 to 0.9 percentage point per year.
This adjustment to the CPI-U-RS could be too big or too small. Gordon and Todd vanGoethem (2005) and Gordon (2006), for example, find that over some periods the CPI-U understated price increases for housing and clothing. The commission itself argued that its estimates tended to understate the bias (Advisory Commission 1996, section VI; Gordon 2006, p. 13), but that the truth could lie anywhere in a fairly wide band. Others, such as Jerry Hausman (2003), have also argued that the commission understated the bias. Dora Costa (2001) concludes that the CPI-U overstated inflation by 1.6 percentage points per year between 1972 and 1994. Bruce Hamilton (2001) uses a different data source and concludes that the CPI-U overstated inflation by 3.0 percentage points per year between 1972 and 1981 and by 1.0 percentage point per year between 1981 and 1991.