Mr. Greenspan dicusses the accuracy of the US consumer price index
Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan
Greenspan, before the Committee on Finance of the US Senate on 30/1/97.
Mr. Chairman and members of the Committee, I appreciate the opportunity to
appear before you today. The Committee is faced with a number of complex policy issues that
will have an important bearing on the fiscal health of the nation and the welfare of our people
well into the next century. I will be happy to respond to questions relating to any of those issues,
but in my formal comments this morning I intend to focus on the accuracy of the consumer price
index.
I would like to begin by commending this Committee for having done so much to
bring the issue of possible bias in the CPI to the attention of the Congress and of the nation in
general. The hearings conducted by this Committee in 1995, as well as the report produced by
the advisory commission that was sponsored by this Committee, have advanced the discussion
considerably. These efforts, along with the continuing contributions of the Bureau of Labor
Statistics' research staff, have added importantly to our understanding of the sources of
measurement error in the CPI.
Any index that endeavors to measure the cost of living should aim to be unbiased.
That is, a serious examination of all available evidence should yield the conclusion that there is
just as great a chance that the index understates the rate of growth of the target concept as there
is that it overstates the truth. The present-day consumer price index does not meet this standard.
In fact, the best available evidence suggests that there is virtually no chance that the CPI as
currently published understates the rate of growth of the appropriate concept. In other words,
there is almost a 100 percent probability that we are overcompensating the average social
security recipient for increases in the cost of living, and almost a 100 percent probability that we
are causing the inflation-adjusted burden of the income tax system to decline more rapidly than I
presume the Congress intends.
A major reason for this is that consumers respond to changes in relative prices by
changing the composition of their actual marketbasket. At present, however, the marketbasket
used in constructing the CPI changes only once every decade or so. Moreover, new goods and
services deliver value to consumers even at the relatively elevated prices that often prevail early
in their life cycles; currently, that value is not reflected in the CPI.
For that and other reasons outlined in the Boskin Commission report and other
studies, we know with near certainty that the current CPI is off. We do not know precisely by
how much, however. There is, nonetheless, a very high probability that the upward bias ranges
between 1⁄2 percentage point per year and 11⁄2 percentage points per year. Although this range
happens to coincide with the one I gave two years ago, it does reflect both the improvements in
the index that the BLS has implemented since then and the emergence of evidence suggesting
that the initial problem was of a slightly greater dimension than had previously been estimated.
This estimate is consistent with a number of microstatistical studies as well as an independently
derived macroevaluation by staff at the Federal Reserve Board, which I will discuss shortly.
In judging these evaluations, it is incumbent upon us to resist the evident strong
inclination to believe that precision is the equivalent of accuracy in price bias estimation. If we
cannot find a precise estimate for a certain bias, we should not implicitly choose zero as though
that was a more scientifically supportable estimate.
There is no sharp dividing line between a pristine estimate of a price and one that
is not. All of the estimates in the CPI are approximations, in some cases very rough
approximations. Further, even very rough approximations can give us a far better judgment of
the cost of living, than holding to a false precision of accuracy. We would be far better served
following the wise admonition of John Maynard Keynes that "it is better to be roughly right than
precisely wrong."
Estimates of the magnitude of the bias in our price measures are available from a
number of sources. Most have been developed from detailed examinations of the microstatistical
evidence. However, recent work by staff economists at the Federal Reserve Board has added
strong corroborating evidence of price mismeasurement using a macroeconomic approach that is
essentially independent of the exercises performed by other researchers, including those on the
Boskin Commission. In particular, employing the statistical system from which the Commerce
Department estimates the national income and product accounts, the research finds that
measured real output and productivity in the service sector are implausibly weak, given that the
return to owners of businesses in that sector apparently has been well-maintained. Taken at face
value, the published data indicate that the level of output per hour in a number of
service-producing industries has been falling for more than two decades. In other words, the data
imply that firms in these industries have been becoming less and less efficient for more than
twenty years.
These circumstances simply are not credible. On the reasonable assumption that
nominal output and hours worked and paid of the various industries are accurately measured,
faulty price statistics are almost surely the likely cause of the implausible productivity trends.
The source of a very large segment of these prices is the CPI.
For this exercise, the study used the GDP chain-weight price measures. Although
these price measures are based on many of the same individual price indexes included in the
CPI, they do not suffer from upper-level substitution bias. Hence, the price mismeasurement
revealed by this data system largely reflects shortcomings in quality adjustment and in the
treatment of new goods and services. If, instead of declining, productivity in these selected
service industries was flat, to up a modest 1 percentage point per year, the implicit aggregate
price bias associated with these service industries alone would be on the order of 1/2 percentage
point or so per annum in recent years -- very similar in magnitude to the Boskin Commission
estimate of total quality adjustment and new products bias.
To be sure, it is theoretically possible that some of the measured productivity
declines in these service industries merely reflect mispricing of intermediate transfers among
various industries. Such an occurrence would cause an understatement of productivity in some
sectors, but a corresponding overstatement in others. But the available evidence suggests that for
these particular service industries this theoretical possibility is not of a sufficiently large
empirical magnitude to overturn the basic conclusion that there are serious measurement
problems in our price statistics. Moreover, the study did not attempt to evaluate possible quality
and new products bias in other industries.
Some observers who are skeptical that the bias in the CPI could be very large
have noted that the evidence on the magnitude of unmeasured quality change and the importance
of new items bias is incomplete and inconclusive. Without a doubt, quality change and new
items are among the most difficult of the problems currently confronting the BLS. But since I
raised this issue two years ago in my testimony before this Committee, a number of studies have
documented significant new examples of cases in which the current treatment in the CPI results
in an overstatement of the rate of growth of the cost of living.
There doubtless are certain components of the CPI that are biased downward
because quality change is handled inappropriately. One instance in which there may well be a
problem in this regard pertains to new vehicles, where it may be more appropriate to treat
pollution control and mandatory safety equipment, at least in part, as raising price to a consumer
rather than improving quality, as is the present practice. But the potential downward bias
introduced by current methodology for such equipment can only be slight. We should be
prepared to embrace credible new research on quality adjustment, regardless of whether that
research points to additional sources of upward bias or previously undetected instances of
downward bias. Nonetheless, currently available evidence very strongly supports the view that,
on balance, the bias is decidedly toward failing to appropriately capture quality improvements in
our price indexes. There is little reason to believe that this conclusion will change unless we alter
our procedures.
A more difficult quality related issue is whether to reflect changes in broad
environmental and social conditions in price measures that are used for indexing various
components of federal outlays and receipts. That is, should the CPI reflect the influence of
factors such as the level of crime, air and water quality, and the emergence of new diseases,
which are not specifically related to products that consumers purchase? There is little in the
record to suggest that, when it enacted the indexation of social security benefits in 1972, the
Congress intended for the beneficiaries of that program to be compensated for changes in such
environmental and social factors. Nor do these issues appear to have been raised when Congress
debated the indexation of various tax parameters during the 1980s. Taking account of such
conditions, particularly those that lie outside of the markets for goods and services, would be an
interesting exercise in its own right, but would appear to extend well beyond the original intent
of the Congress.
A considerable professional consensus already exists for at least two actions that
would almost surely bring the CPI into closer alignment with a true cost-of-living index. First,
we should move away from the concept of a fixed marketbasket at the upper level of
aggregation, and move toward an aggregation formula that takes into account the tendency of
consumers to alter the composition of their purchases in response to changes in relative prices.
The BLS already calculates such an index on an experimental basis with a lag of about a year. If
the Bureau adopts the Boskin Commission's recommendation that it publish a "best practice"
version of the CPI with a lag of a year, it should, without question, build that index on the
foundation of a variable marketbasket.
There is a somewhat more difficult issue as to whether the concept of a variable
marketbasket can be applied in "real time," that is, with the same degree of timeliness that
characterizes the current CPI. It is not possible to implement the textbook versions of any of the
so-called "superlative" index formulas in real time, because those formulas require
contemporaneous data on expenditures, and those data are not presently available until about a
year after the fact. However, this hardly forecloses the possibility of implementing an
approximation to a superlative formula, and work should continue on the development of such
an approximation.
A second area that will require attention is the aggregation of prices at the most
detailed level of the index. This is a highly technical area, and an important example of how
research by the staff at the BLS has advanced our knowledge. Without going into the details of
the matter, it is sufficient to say that a selective move away from the current aggregation formula
is warranted, and would probably make a modest further contribution to bringing the index more
in line with the concept of a cost-of-living index.
Beyond these rather limited steps, most of the needed developments will require
time, effort, and quite possibly additional resources. It is important that the Congress provide the
Bureau with sufficient resources to pursue the agenda vigorously. These are difficult problems,
and they cannot be solved tomorrow or next week. But with adequate support and diligent effort,
the pace of improvement should quicken. Moreover, an accelerated pace of BLS activity, and
heightened congressional interest should galvanize analysts outside the government to contribute
to the research effort.
Where will this longer-term effort be required? One of the key areas, by all
accounts, is quality adjustment. As the Bureau has rightly noted, they do indeed already employ
a variety of methods to control for quality change, but available evidence suggests that these are
not sufficient to the task. Unfortunately, making improvements on this front will be difficult:
Each item will have to be considered on its own, and there may well be limited transfer of
knowledge from one item to the next.
Another key area on the longer-term agenda will be the estimation of the value of
new products to consumers. Significant innovations, such as the personal computer, the cellular
telephone, and the heart bypass operation create value for consumers, even at their typically high
initial prices; moreover, this value is even greater at the much lower prices that often prevail
when new products are, in fact, introduced into the CPI. A true cost-of-living index would
reflect this value and its implication for the true rate of growth of the cost of living. The CPI
does not reflect it, and accordingly fails to capture a significant offset to price rises in other
products. Deriving an estimate of this value and building it into the CPI will not be an easy
undertaking. But conceptually, it is unquestionably the right direction to be heading, and some
recent research suggests that it could measurably affect the index.
Over time, we will need to investigate alternative sources of data. Already, there
is interesting work being done to develop techniques for processing data collected from bar-code
scanners at the check-out counter. Scanner data will allow the BLS to track not just a small
sample of products, but virtually the entire universe of products in selected lines of business and,
perhaps most importantly, virtually the universe of transactions, regardless of whether those
transactions happen on a weekday, at night, or on a holiday.
We should also move to improve our understanding of the value that consumers
place on their own time. Absent such knowledge, it will be impossible for the BLS to estimate
the value of many goods and services that mainly serve to enhance convenience and save time.
Finally, we will have to attempt to build an understanding of why consumers shop
at the places they do: What characteristics of an outlet are important, and how much so?
Location, hours of operation, inventory, and quality of service all are likely influences on the
value that consumers place on their shopping experience, and all will be important in helping the
BLS to develop a more sophisticated statistical method for dealing with the appearance of new
consumer outlets, including those that operate over the Internet.
Even if the BLS moves aggressively, some upward bias will almost surely remain
in the CPI, at least for the next several years. Two years ago, in testimony before this
Committee, I suggested that a workable structure for dealing with this situation might involve a
two-track approach. That suggestion still seems to me to make sense. The first track would
involve action by the BLS to address those aspects of the bias that can be dealt with in relatively
short order, say within the next year. The second track would involve the establishment of an
independent national commission to set annual cost-of-living adjustment factors for federal
receipt and outlay programs. The Commission would examine available evidence on a periodic
basis, and estimate the bias in the CPI taking into account both the latest research on the sources
and magnitudes of the bias, and any corrective actions that had been taken by the BLS. This type
of approach would have the benefit of being objective, nonpartisan, and sufficiently flexible to
take full account of the latest information. Moreover, there is no reason why the two tracks
could not proceed in parallel.
Without the second track, we are implicitly assuming, contrary to overwhelming
evidence, that the most accurate estimate of the bias is zero. There has been considerable
objection that such a second track procedure would be a political fix. To the contrary, assuming
zero for the remaining bias is the political fix. On this issue, we should let evidence, not politics,
drive policy.
We have an overarching national interest in building a better measure of
consumer prices and in implementing more rational indexation procedures. Through these
efforts, we are most likely to ensure that the original intent of the relevant pieces of legislation
will be fulfilled in insulating taxpayers and benefit recipients from the effects of ongoing
changes in the cost of living. At present this objective is not being met.