What is Chained CPI and Why Should I Care?

by Michael on Apr 16, 2013 · 1 comment

Photo of a Big Heavy Chain

In addition to putting a cap on retirement accounts, President Obama’s budget proposal includes a possible transition to the so-called “chained CPI” for inflation adjustments.

This includes things like cost-of-living increases for Social Security recipients as well as various tax provisions that are indexed to inflation.

But what exactly is the chained CPI? And, perhaps more importantly, what effect would these changes have on your pocketbook?

As you’re likely aware, most inflation adjustments at the federal level are based on the so-called Consumer Price Index for all Urban Consumers, or CPI-U. This is an index, updated monthly, that tracks the prices paid by urban consumers for a “representative basket of goods and services.”

Note: Retirement programs such as Social Security are currently indexed to the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) but, under the President’s proposal, this would change going forward.

The CPI-U has been criticized in the past on the grounds that it overstates inflation due to substitution bias. That is, it ignores the tendency of people to substitute one product for another (where possible) when relative prices change.

For example, if the price of beef increases, people might start eating more chicken, thereby blunting the effects of this price increase on their overall cost-of-living.

Well… Back in 2002, the BLS started publishing an alternate price index called the Chained Consumer Price Index for All Urban Customers (C-CPI-U). The C-CPI-U, which is the “chained CPI” that you’ve been hearing so much about, is intended to more accurately reflect true changes in the cost of living.

You can read all about this in great detail if you wish, but the short version is that the C-CPI-U results in lower inflation estimates by accounting for the tendency of people to minimize their costs by making substitutions when/where possible.

The net effect will be to reduce cost-of-living adjustments for Social Security recipients, and to reduce adjustments in things like personal exemptions, the standard deduction, income thresholds and phase-outs for a variety of tax deductions, exclusions, and credits, and so forth.

It will also affect the income thresholds for individual tax brackets, causing them to rise more slowly. The end result will be that people will more easily cross into higher brackets as their income increases.

In other words, the transition will set the stage for both reduced spending and increased revenue at the Federal level. I’ll leave it to you to decide whether this is a good or bad thing. Feel free to share your thoughts in the comments section.

1 Chris @ Awesome Financial Future April 17, 2013 at 1:47 am

Thanks, Michael, I’d seen the term, but now I understand it. Now that I do… three big faster-than-average inflators are health care, energy, and college tuition. I wonder what I’ll substitute? (I’m already eating chicken!)

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