Fixing the Inflation Index - But Is It Really Broken?

"The CPI fix is on."

That's how Wall Street economist Stephen Roach sees it - the drive in Washington to alter Social Security benefits and income taxes by "fixing" the consumer price index.

Several prominent economists argue that the CPI overstates price increases, and politicians see a fix as helping to balance the federal budget by 2002.

But Mr. Roach says the index may actually understate inflation.

"It's an exercise that makes voodoo economics look cheap by comparison," says the chief economist at Morgan Stanley & Co., a major New York investment bank.

The result would be reduced cost-of-living increases in Social Security checks and bigger income tax bills. Both are currently linked to the CPI.

Roach's complaint is a technical one. He says the CPI is not taking adequate account of rising home prices. Housing accounts for about 20 percent of the CPI. The Bureau of Labor Statistics, using a standard called "owner's rental equivalent," asks homeowners how much they could rent their house for - not its value.

Matthew Shapiro, an economist at the University of Michigan, Ann Arbor, disagrees, arguing that the current practice is "conceptually correct."

Roach calls it a "theoretical exercise" that doesn't work, especially for people buying homes when prices rose 5 to 6 percent last year.

And there are other reasons inflation may be understated. One example: In some industries, such as retail service, quality may have declined rather than increased. (Quality improvements are a key factor cited by those who see an upward bias in the CPI.)

Momentum for change

Still, momentum is growing in Washington for a commission to put a precise number on the CPI's alleged upward bias.

Last week, Federal Reserve chairman Alan Greenspan repeated his call for such a group of independent experts.

Senate majority leader Trent Lott (R) of Mississippi favors the idea. And both President Clinton and his budget director, Franklin Raines, have spoken favorably of the idea. Mr. Raines this week said the White House had not made a final decision.

On Tuesday, Mr. Greenspan told the House Budget Committee there was "almost a l00 percent probability" that Social Security pensioners were being overpaid for increases in prices.

"Garbage," responds Dean Baker, an economist at the Economic Policy Institute, a Washington think tank. "The evidence does not give you 100 percent."

Estimating the bias

On the other side, Mr. Shapiro says, "It's actually a 99 percent probability - not 100 percent" that the CPI exaggerates.

In a paper last year, Mr. Shapiro wrote that the CPI's upward bias was "centered on" 1 percentage point a year. There is a 10 percent chance that the bias is less than 0.6 percentage points and a 10 percent chance that it is greater than 1.5 percentage points per year, the paper argued.

A Senate commission in December said the upward bias was about 1.1 percentage points.

Trimming indexation by that amount could slice $1 trillion from the deficit in the next 12 years and about $350 billion from Social Security pensioners.

Since then, the debate has been building. Republicans don't want to be labeled as the party that takes money from grandma to give tax breaks to the rich. But it is not entirely a partisan affair.

In the House, conservative Democrats propose saving $103 billion from the budget over five years by shaving 0.8 percentage point from the CPI adjustment.