Index likely to reduce cost of living raises

By Tom Philpott

Military retirees, Social Security recipients and others drawing federal payments were tempted to grumble at Congress or the White House when the past two Januarys brought no cost of living adjustment.

The real culprits were a deeply distressed economy, which drove pri

ces down, and a logical process, set up 40 years ago, to track inflation and adjust federal payments to protect their purchasing power.

Those who did complain about lack of adjustments might soon have a more legitimate reason to grouse: a new yardstick for setting the adjustments called the Chain Consumer Price Index for All Urban Consumers.

First, let’s review why the cost of living adjustment stopped for two years.

Starting in the last quarter of 2008, the cost of goods and services fell sharply while housing and financial markets collapsed. Yet the last adjustment, in January 2009, had been shaped by price data collected months earlier after gasoline prices had hit new highs. So federal entitlements jumped 5.8 percent, the largest bump in 25 years, as prices slid across the marketplace.

The tool long used by the Bureau of Labor Statistics to track inflation and set cost of living adjustments is the Consumer Price Index of All Urban Wage Earners and Clerical Workers. After the 2009 increase, no adjustment could be paid until prices for a market basket of goods and services surpassed levels used for that 5.8 percent bump.

The traditional index only cleared that milestone in January 2011. Through June this year, the index shows retirees in line for at least a 3.2 percent boost in cost of living next January, with inflation from July through September still to be measured.

The knock on the long-used index is that it overstates inflation through “substitution bias,” ignoring how consumers respond to price changes. For example, if a family spent $100 last month on beef and the price doubles, their cost-of-living won’t actually rise by $100, economists contend. Instead the family will buy less beef and more of something else like chicken.

This issue surfaced 15 years ago. The Bureau of Labor Statistics has changed how it calculates cost of living adjustments since then. But it only takes into account how consumers might buy more of a regional brand of hot dog versus a more popular national brand. Economists say the index still ignores “upper level substitution” which occurs across product category, as when consumers decide to buy more apples as oranges become too costly.

The latest index, the Chain Consumer Price Index for All Urban Consumers, which was established in 2002, addresses this, tracking not only prices but changes to a representative market basket month to month. It then “chains” months together to calculate overall cost of living.

Adopting the chain index as a means of determining cost of living adjustments has been recommended by every group looking for ways to address the federal debt crisis. It would save roughly $300 billion on entitlement spending over just the first decade after it took effect. It has its critics, however. They argue the chain index ignores the fact that quality of life is impacted if consumers replace products they prefer with products they can better afford.

For individual federal retirees and Social Security recipients, the chain index would dampen current cost of living adjustments an average of 0.25 to 0.3 percent per year. That difference is expected to grow more pronounced over time.

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