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What is Chained CPI?

Posted By Jim On 04/11/2013 @ 7:15 am In Personal Finance | 15 Comments

If you saw President Obama’s FY2014 budget, one of the biggest pieces of news in it was a change in the calculation of the cost of living adjustment, or COLA. COLA is used to figure out how much to increase many government payments, the most important of which, especially for retirees, is probably Social Security payments [3]. The switch from the current inflation measure to what is known as “chained CPI” is estimated to reduce the federal debt by $230 billion dollars ebacuse chained CPI is expected to grow between 0.25% – 0.30% slower [4] than the CPI they use now.

As is the case with any small percentage, the initial impact would be small and grow over time. As the years pass, the impact would be greater. “According to the National Women’s Law Center, a retiree who was collecting $17,520 last year would see 6.5% less, or $1,139, by age 85, if chained CPI were adopted now. A decade after, their payments would be 9.2% smaller, or $1,612.”

So what is Chained CPI?

What is Chained CPI?

Isn’t that the million dollar question? Chained CPI, or C-CPI-U, is a relatively recent measure (August 2002 was the first release) and the big difference is that it takes into account how people substitute products in response to price changes. The BLS has a more in-depth explanation, the term Tornqvist formula is used, but the basic gist is that when prices increase, people don’t always just pay more for the same products. They pay for cheaper versions or otherwise make what they have last.

Chained CPI is designed to capture this and it’s the reason why it grows at a slower pace than CPI-U. I didn’t look into the calculation or the data inputs but the explanation made sense. In theory, Chained CPI should be more accurate since it models more closely consumer behavior but as is the case with any measure, the devil is in the details.

What is used now?

There are several CPI figures and the one that most people talk about is CPI-U, or the Consumer Price Index for All Urban Consumers. Interestingly enough, Social Security’s COLA uses CPI-W. CPI-W is the Consumer Price Index for Urban Wage Earners and Clerical Workers. The CPI-W is a subset of the CPI-U and according to the Seattle.gov [5], CPI-W covers 32% of the U.S. population while CPI-U covers around 87%. The theory goes that the CPI-W is used for many COLA adjustments in labor contracts so they used it for Social Security.

Is this a good thing?

It depends on where you’re standing. If you collect payments, the answer is clearly no. You’ll get less because COLA adjustments will be smaller. If you make payments, the answer is clearly yes. You pay less because COLA adjustments will be smaller.

Is it fair? That depends on your confidence in the accuracy of C-CPI-U … but no one ever really cares about “fair.” It’s always about how it impacts you so it’s a moot point.

(Photo: ZeroOne [6])

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[2] Email: mailto:?subject=http://www.bargaineering.com/articles/chained-cpi.html

[3] Social Security payments: http://www.ssa.gov/oact/cola/latestCOLA.html

[4] grow between 0.25% – 0.30% slower: http://money.cnn.com/2013/04/10/news/economy/chained-cpi-social-security/index.html?hpt=hp_t2

[5] Seattle.gov: http://www.seattle.gov/financedepartment/cpi/overview.htm

[6] ZeroOne: http://www.flickr.com/photos/70591690@N00/2694368964/

Thank you for reading!