Three ways to make the CPI honest

As the economy struggles under rising prices, attention has increasingly focused on the adequacy of various price indexes to measure inflation in a way which clearly demonstrates the deterioration in the level of the average consumer's well-being or welfare.

In particular, consider the Consumer Price Index (CPI), currently rising at an annual rate of 18-20 percent. It has been invoked to fault President Carter by several contestants in the presidential primaries, and also by a number of leading academic economists.

But an important group of economists and senior policymakers have correctly argued that the CPI seriously exaggerates the degree to which the income of the average wage earner has been eroded by inflation. The principal reason is that it accords such a large weight (34 percent) to new home purchases whose prices have been soaring because of high mortgage interest rates.

Because so many wage negotiations use the CPI as a target for wage settlements and escalator clauses, it follows that, if the CPI overstatesm the deterioration of average wages, increases based upon this measure will overcompensatem wage earners and inflation.

To make the CPI a truer measure of inflation, there are at least three important types of change that should be considered:

* Adopt something like the Canadian approach to house price change. This is based not on the purchase price of new homes but on the average monthly mortgage payments for specified home types as determined by monthly statistical sampling procedures. Thus the high mortgage interest rates, not to speak of high new house construction costs, figure only in proportion to the number of new house purchases in relation to the total stock.

To see the effect on the housing component of the CPI, imagine that one homeowner in 20 buys a new house every month and that the mortgage rate has risen from 10 percent to 15 percent in a year. The US mortgage interest subindex would then rise by 50 percentm whereas the equivalent Canadian subindex would show a gain of only 2.5 percentm over the year. (In both cases these subindexes would be averaged in with other component indexes like fuel, food, home operation, and clothing to derive the overall index.)

* Replace automobile costs by annual depreciation figures. The idea is that as consumers have to spend ever more on fuel (heating and gasoline), fuel-intensive products, and higher-cost petrochemicals, a smaller share of their budgets will be available for other purchases. But this may influence consumers to look for much better quality, especially in big-ticket items like cars, and encourage them to spend still more if they can get longer service life. Instead of spending 15 percent more for the same product, why not pay 25 percent more for one that lasts 50 percent longer? In this case, annual car depreciation would actually fall by one-sixth. But the purchase price index would have risen by 25 percent, suggesting that we were 25 percent worse off whereas in fact we were 16 percent better off.

Naturally, even if implemented in the next few years, the effects of the switch from price to depreciation would be slow in coming. For they would depend on the change in the composition of the nation's vehicle fleet. That the task would be difficult, however, should not deter us anymore than the task of sampling homeowners is an obstacle to that more meaningful approach to home cost measurement in Canada.

* Use total income, rather than wages in figuring wage settlements and escalator clauses tied to the CPI.

When the Department of Commerce calculates the gross national product it includes an item called "imputed rent of owner-occupied dwellings." This is essentially an attempt to measure the income represented by the services flowing from homes. (The owners' mortgage payments and other expenses, of course, are netted out.) This imputed rent is in principle based on comparable new house costs (with age adjustments), but there is some evidence that the imputations have been lagging behind the rapidly rising new purchase prices.

If people learned to regard this imputation as part of their real income, their wages would not have to rise so fast to offset the CPI. An important component of their income -- the imputed rent -- would be rising automatically every time the CPI rose a point.