Guest Column

Inside the inflation numbers on Social Security

One of the proposals to get federal spending under control is to cut the rate of growth of Social Security benefits, either by delaying eligibility or by employing a less generous method of adjusting benefit checks for inflation. The second approach is more mysterious than the first, calling for a "chain-weighted consumer price index (C-CPI)." What does this mouthful actually mean, and how would it affect Social Security benefit checks?

The method of inflation adjustment is important because once the amount of the recipient's first check is determined, all subsequent checks are based on the dollar amount of the first check, adjusted for inflation. Consequently, the choice of the inflation adjuster is critical, both to the recipients of these checks as well as to those trying to get control of the national budget.

Is there more than one consumer price index? Yes, there are several. The "headline" index, or CPI, is the one reported in the popular press, and it measures the change in the amount of money required for the average consumer to continue with the same buying habits year after year for several years beyond an initial or base year. Even though the prices people pay may persuade them to change their buying habits, the headline CPI shows how much more money would be needed to keep their buying habits unchanged, that is, keep them buying the same combinations, or "basket," of goods and services. If the index rises by 5 percent, that means that the purchases made in the base year would cost 5 percent more if made this year. Put another way, by the headline measure, inflation was 5 percent.

Since the headline CPI is calculated as if the market basket remains unchanged over the years, economists have questioned the appropriateness of its use as a cost-of-living adjuster for people whose buying habits change more frequently. The current effort is to find a more realistic inflation adjuster that reflects the many substitutions people actually make as they age. In chain-weighted formulas, the buying habits of people are observed each year. A chain-weighted index identifies the change in income needed to buy last year's bundle at this year's prices, not the base year bundle from 10 or 15 years ago. Each year's bundle is used for only one year — for a one-year comparison, and then it becomes the base for next year's calculation.

By using the buying habits from the most recent comparison year, the chain-weighted index captures the changing nature of consumer decisions. Effectively this means that substitutions are taken into account when determining how much of an increase in monetary income is required to maintain living standards, year by year. Such indexes are inherently a lesser amount than the CPI would recommend. The reason is that some of the substitutions consumers make are in direct response to inflationary conditions.

If their substitutions — vegetarian dishes for red meat; apartment living for owner-occupied homes; staycations for vacations — result in no greater monetary expenditure for them, then the C-CPI yields zero inflation — even though the consumer has strenuously attempted to live with a reduced standard of living precisely because there is price inflation.

The Congressional Budget Office estimates that over 10 years the use of the chain-weighted CPI would result in 5 percent less inflation than the "headline" CPI. Many budget analysts recommend the chain-weighted formula when adjusting all federal programs for inflation.

But when determining the appropriate adjustment of Social Security checks for the inflation that older people face, there is a concern that the data used in the C-CPI may reflect the purchase substitutions of the general population more than those of the elderly. In fact, during the 1990s, the Bureau of Labor Statistics calculated a CPI-E index using data from just the elderly population. When restricting the data to the elderly population, the measured inflation index rose 1 percent faster over the five-year period 1990 to 1995 than did the headline CPI.

Clearly, use of CPI-E would adjust Social Security benefits more generously than now, counter to the goal of trimming the costs of this program. So, the choice of inflation index to cut the growth of Social Security is tricky since the index that would reduce the growth of the Social Security program underestimates the actual inflation facing the elderly.

Charles O. Kroncke is associate dean in the University of South Florida College of Business. William L. Holahan chairs the department of economics at the University of Wisconsin-Milwaukee.

Inside the inflation numbers on Social Security 08/17/11 [Last modified: Wednesday, August 17, 2011 7:57pm]

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