Personal Finance: What is chained CPI in Obama's budget proposal?

photo Chris Hopkins

Republicans and Democrats are inching toward a more constructive engagement in the battle to defuse the debt bomb. President Obama made a significant contribution last week with the release of his proposed budget, in which he advocated a shift to so-called "chained" CPI to adjust spending and taxes for inflation.

This focus on chained CPI will intensify over the next few weeks as more attention is focused on the concept. So just what is it, and how will it affect the average American?

Most federal benefit programs automatically adjust for inflation. Social Security, for example, ratchets up each year based upon a specific price index. This was not the case before 1975, when Congress anchored yearly benefits to changes in the Consumer Price Index, or CPI. First constructed in 1913, the CPI is the most widely recognized price index for the U.S. economy and was therefore selected as the obvious benchmark for benefit payments.

However, it is well known that

the CPI overstates the true cost of living over time. Hence the Bureau of Labor Statistics began publishing an alternative index in 1999 that seeks to more accurately track the household inflation rate. This revised metric, called "chained CPI", enjoys broad (although not universal) acceptance among economists as a much better reflection of changes in the cost of living.

The traditional CPI is constructed by measuring the prices of a static collection or "basket" of 211 different items in 38 localities each month. The resulting matrix of price-location data is combined into a weighted average we call the CPI. Since the mix of items in the basket is revised only once a year, changes in consumer behavior are not fully reflected. For example, rising tuition at private universities will entice some students to enter state schools or community colleges. This common behavior, known as the "substitution effect", is largely excluded from the traditional CPI.

Chained CPI makes monthly adjustments to the basket of goods as consumers alter their consumption behavior. These changes in the mix of goods are linked or "chained" together month to month to yield a better estimation of the cost of living.

Estimates by the Congressional Budget Office suggest that the CPI overstates inflation by 0.2 percent to 0.3 percent. Shifting to chained CPI would constrain the growth of government benefit programs to a rate closer to the real cost of living increase. It would also generate more tax revenue by retarding the indexing of income tax brackets, resulting in a deficit reduction of around $200 billion over a decade.

The average Social Security beneficiary will hardly notice the change in any given year. A typical retiree would receive a $4 smaller monthly increase in payments next year at present inflation rates. Most of the common proposals also include a raise or "bump" for retirees in later years to help offset the slower increase over time.

Chained CPI is not the whole answer to the problem of unsustainable entitlement growth, but it is one of the easiest to agree to.

Christopher A. Hopkins CFA, is a vice president at Barnett & Co.