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December 12, 1 980 IndexProblems The problem of fighting inflation can be aggravated by the difficulty of knowing just how bad the problem is. Statisticians try to deal with this difficulty by devising a number of different yardsticks to measure changes in price levels. Yet most discussion still centers around the consumer-price index (CPI) and its variants, simply because public and private policymakers use that index far more than any other yardstick in their policy decisions. (Through indexing provisions, wages and other payments of nearly 80 million people are dependent on CPI fluctuations.) Statisticians continually try to improve various inflation measures, but recognize that no index measure can be perfect. The methods used in constructing indexes depend greatly on the uses for which they are intended. Any "cost of living" index, such as the consumer-price index, is based upon a comparison of household "utility" (or perceived well-being) in two different periods. Index makers assume that utility is constant in each time period, and that a change in the cost of living is the ratio of income or expenditures that will leave an individual or household on the same "utility map"-or equally well off-as before. In the words of Lawrence Klein and Harry Rubin, "The true cost of living is defined as the ratio of two incomes. The denominator of this ratio is the actual base-period income. The numerator is the smallest income required in order to buy, at current prices, that complex of goods which wou Id leave one on the same level of uti Iity as was experienced in the base period." Weighting crucial The key decision facing statisticians is how best to weight the various prices in the two time periods being compared. One approach (Laspeyres) is to weight prices of individual goods and services at the quantities existing in some base period. (This index was developed by the 19th-century French-German economist, Etienne Laspeyres.)An alternative approach (Paasche) is to weight prices at current-period quantities. (This index was developed by Laspeyres' German contemporary, Hermann Paasche.) The CPI is a Laspeyres index, while the personalconsumption expenditures (PCE)"deflator" is a variant of a Paasche index -and that distinction makes for some important differences in results, as we shall see below. The Bureau of Labor Statistics (BLS)determined the base-year weights in the present consumer-price index by a survey of consumer expenditures involving about 20,000 family units in the 1 972-73 period, either through quarterly interviews or through diaries of actual expenditures maintained over a two-week period. On that basis, BLSdeveloped a statistical market basket involving almost 400 separate categories of goods and services. CPI and alternatives . The B.LScollects prices for individual goods and services from a number of sources each month. The sample includes about 24,000 retail establishments, such as supermarkets, cleaning establishments, repair shops, and doctors and lawyers' offices. The Commerce Department's Bureau of Economic Analysis (BEA) follows a different procedure in developing its price indexes"implicit price deflators" -for GN P and its components. (The deflator for personal consumption expenditures is the most important of these yardsticks, being the closest alternative to the CPI.) In developing its price deflators, BEA draws upon a variety of other price series to deflate segments of currentdollar GN P to a constant-dollar basis. It should be emphasized that the two series differ in construction partlybecause they are designed for different purposes. The CPI is 'designed expressly to measure the escalation of prices. The PCEdeflator is essentially a byproduct of the process involved in reducing current-dollar G N P to a constantdollar volume. mainly because it already reflects some of the change in consumption patterns with which consumers respond to price increases. BEA does not deflate by individual commodities, because this would create massive operational problems for anything as complex as GNP. Instead, it deflates expenditures for a variety of commodities with fixedweight price indexes, with the indexes combining price relatives for individual types of commodities included in the expenditures component. (A price relative is the ratio of current price to base-period price.) Thus, the implicit deflator involves current-period weighting among sub-indexes-the Paasche approach-and fixed weighting within the components. Consequently, we might expect the "real" cost-of-living rate to fall somewhere between the CPI on the high side and the peE deflator on the low side. This relationship hasn't held consistently over the past generation, at least during the relatively stable period of the 1960's, but it has held during most of the recent period of accelerating inflation. The mean annual increase in consumer prices over the 1968-79 period was 6.7 percent for the CPI and 6.q percent for the PCEdeflator, compared with annual increases of roughly 1.8 percent for both indexes in the 1961 -67 period. In a period of relatively stable prices, the price elasticities between goods that are close substitutes generally aren't great enough to respond to relatively modest price differentials between the goods. But when prices are rising, the fixed-weighted market basket becomes distorted by changes in tastes-and especially by substitution of less expensive for more expensive goods. Actually, BEA depends heavi lyon BLSdata in compiling its deflators; more than threequarters of the PCEdeflator is directly comparable with the coverage in the CPI. The other one-fourth includes items that are treated differently for conceptual reasons, such as net purchases of used cars, expenditures for nonprofit institutions, and (especially) the rental value of owner-occupied housing. Comparing necessities Considerations such as these help us evaluate the many controversies over the CPl's value as an inflation indicator. Forexample, there is the criticism, made by the National Center for Economic Alternatives, that the CPI understates the rise in prices of the necessities purchased by the poor. In this view, the inflation of the past decade has been most prevalent in the prices of basic needs-food, housing, energy and medical care. Thus, inflation has fallen most harshly upon the poor and middle-income families who must perforce devote most of their income to such necessities. To test this argument, the Center for Economic Alternatives devised a "necessities price index" on the basis of the CPI series for food, shelter, energy and medical care. This series increased at an 8.6-percent annual rate for the decade of the 1970's, compared with a 7A-percent annual rate of increase in the official CPI (see chart). Comparingindexes The CPI, a Laspeyres index, may overstate price increases-mainly because as prices change, consumers will alter their consumption patterns to include smaller amounts of products with large price increases and larger amounts of products with small price increases. (If consumers can do this without reducing their total satisfaction, the use of base-period commodity selections will tend to overstate declines in living standards.) The PCEdeflator, a modified Paasche index, conversely may understate price increases- 2 Percent 10 Consumer Price Change Average (1970-79) 8 6 4 2 o Necessities Necessities (Revised) This relatively crude index may overstate the actual inflation rate for the poor, however, as has been suggested by the Brookings' economist Joseph Minarik. The latter devised an "improved necessities index" by adding apparel (an obvious necessity), deleting the restaurant-food component (a relative luxury), and substituting the residential-rent component for the home-ownership component (because low-income families normally rent rather than buy.) Minarik's necessities index increased at a 7.0-percent annual rate over the decade-considerably less than either the official CPI or the crude necessities' index. But the PCEdeflator increased at an even slower pace, at a 6.6percent annual rate over the decade, partly reflecting its derivation as a Paasche-based index, as opposed to the Laspeyres' basis of the other indexes. This difference was widest in 1979, when the PCEdeflator increase (10.2 percent) ranked two percentage points below the rise in the Minarik necessities index, three percentage points below the official CPI increase, and seven percentage points below the rise in the crude necessities index. PCE Deflator period-and not on the entire housing stock, as is sometimes erroneously believed. (Still, that weighted figure overstates reality in periods of low housing activity such as the present.) In response to the demand for a better theoretical measure of housing costs and its own desire to improve the existing series, BLS now publishes five experimental measures of home-ownership costs. These alternative measures yield quite diverse results in comparison with the official home-ownership component, which rose 23.8 percent between June 1 979 and June 1 980. However, BLS estimated much smaller weights for these alternative measu'resthan for the official home-ownership component, which accounts for 22.8 percent ofthe total index. Thus, substitution of any but one of the five low.-weighted alternatives would help dampen the sharp rise in the overall CPI caused by soaring home-ownership costs. What can policymakers learn from all these statistical considerations? Perhaps the strongest conclusion is that the CPI tends to overstate "actual" inflation at the present time, because of the index's general weighting procedures and its overweighting of homeownership costs. This suggeststhat 80 million workers, pensioners and others may be getting more than their due, to the extent that their incomes adjust directly to increases in the CPI. In devising a solution, policymakers would'do well to apply more sophisticated measures, such as CPI variants or the peE deflator, in future indexing agreements-and in future discussions of the inflation problem-ail the while recognizing that the various yardsticks will differ greatly in construction because they are basically designed to do different things. Comparinghousingcosts Part of the difference in this regard, and part of the basic criticism of the CPI, centers around the CPl's treatment of housing costs. Houses and other durable goods yield a stream of consumer services-such as shelter and transportation -which are consumed during the period covered by the index. Critics thus argue that such goods should not enter the index as a single purchase but as some measure of current user cost or consumption. The official CPI includes five components in the base weight for home ownershipproperty taxes, property insurance, home maintenance and repair, total price paid for the home, and total contracted interest payments over half the mortgage term. The weights for the last two items are based on about six percent of the total-the percentage who purchased homes during the base Herbert Runyon 3 U018U!4SPM 4Pln .. uo8aJO e ppPi\aN !!PMPH CD P!UJoJ!IP:) puozP V" II) CD) @£\\Jr@<§@;@ :t1 BANKINGDATA-TWELFTHFEDERAL RESERVE DISTRICT (Dollaramountsin millions) SelectedAssetsand liabilities large CommercialBanks Loans(gross,adjusted)andinvestments* Loans(gross,adjusted)- total# Commercialand industrial Realestate Loansto individuals Securitiesloans U.s.Treasurysecurities* Othersecurities* Demanddeposits- total# Demanddeposits- adjusted Savingsdeposits- total Timedeposits- total# Individuals,part.& corp. (LargenegotiableCD's) WeeklyAverages of Daily Figures MemberBankReservePosition ExcessReserves (+ )/Deficiency(-) Borrowings Net freereserves (+ )/Netborrowed( -) Amount Outstanding 11/26/80 145,030 122,833 36,723 49,861 23,936 1,206 6,735 15,462 45,911 32,238 29,142 69,482 60,339 27,274 Weekended 11/26/80 n.a. 299 n.a. Change Changefrom yearago from Dollar Percent 11/19/80 1,610 9,736 7.2 1,485 10,641 9.5 943 4,782 15.0 7,092 16.6 384 73 268 0.3 - 13.0 180 62 94 679 9.2 1.4 31 226 2,299 5.3 658 112 1,173 3.8 - 197 440 1.5 11,019 1,596 18.8 1,466 10,451 20.9 812 5,521 25.4 Weekended Comparable year-agoperiod 11/19/80 n.a. 245 n.a. 24 107 83 * Excludestradingaccountsecurities. # Includesitems.notshownseparately. Editorialcommentsmaybeaddressed to theeditor (WilliamBurke)or to theauthor.... 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