Why does the consumer price index exaggerate the inflation rate?

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kipling2448 | (Level 3) Educator Emeritus

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The Consumer Price Index (CPI) is a picture of the variation in prices of a select group or “basket” of common goods and services. The United States Bureau of Labor Statistics (BLS) compiles the data and uses it to estimate the rate of inflation at a certain point in time. The BLS defines the CPI as a program that “produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.” [www.bls.gov/cpi/]

In addition to collecting data on the prices of basic goods and services -- which include all types of items, from individual clothing categories (e.g., jeans) to kitchen appliances -- the BLS utilizes a process called “weighting,” which involves assigning values to each category of items. The cumulative effect of the processing of the price data and the weighting of items to better reflect a category’s representation within the broader economy produces the CPI.

The reason the CPI may not accurately reflect the actual rate of inflation as a measure of its impact on consumers is because the process by which it is derived is imprecise. The CPI does provide a very good estimate of the rate of inflation, but it is subject to error, and may under- or overestimate the actual rate. The process of weighting can skew the outcome. The BLS has been aware of concerns that the CPI has been prone to exaggerate the rate of inflation, and has implemented changes in the formula it uses to determine it over the years, including the use of additional variables such as product substitution and qualitative factors. It is because of the imprecise nature of the process by which BLS produces the CPI that alternative methodologies have been introduced by individual economists. Because the rate of inflation directly influences major investment decisions, large financial services firms often employ economists who produce their own estimates using their own methodologies.

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