A Change to the CPI Methodology

Well, it's that time of the month again – when traders anxiously wait for the latest Consumer Price Index (CPI) print to hit the wires. You can almost picture them huddled around their screens like kids waiting for a new episode of their favorite TV show. They're all on edge, biting their nails and refreshing their screens every two seconds, hoping for that sweet, sweet CPI data to arrive. It's like waiting for a package from Amazon, except instead of a new pair of shoes, they're getting a glimpse into the current state of the economy. Will inflation be up or down? Will the Fed raise interest rates? It's all so thrilling. It's no wonder traders are so addicted to this monthly ritual. Who needs Netflix when you've got the Consumer Price Index? Before the next CPI print is released, the US Bureau of Labor Statistics (BLS) will change the methodology and weightings of the CPI calculation, and this is not the first time. In 1983, the US government significantly changed the CPI calculation. Previously, CPI had included home prices, which factored in not just the cost of purchasing a home but also mortgage payments and maintenance costs. However, the government switched to using rental prices to gauge the cost of housing instead. The reasoning behind this change was that homes are viewed as investments, and as such, house prices tend to appreciate over time, potentially resulting in a profit for the owner when they sell the property.

On the other hand, rent is considered consumption since it doesn't leave the tenant with an asset they can sell. While the change in methodology may make sense from an economic perspective, critics argue that it has significant downsides. They claim that by excluding home prices, the CPI underestimates the cost of living when house prices rapidly increase. This can be particularly problematic for first-time buyers, who face higher costs to enter the market. Some critics go so far as to suggest that if the government still used the old methodology, its reported inflation rate today would be much higher than in the 1980s.

Another significant change was that In the past, economists collected a basket of items, such as eggs, milk, and shampoo, and tracked their prices over time, updating the basket only occasionally. However, this method was criticized for potentially overestimating inflation since it needed to account for consumers adjusting their spending habits both over time and as prices increase. To address this issue, economists began updating the basket of items more regularly about 20 years ago. Today, the weights are reset every two years to reflect current spending patterns accurately. Additionally, economists now account for substitutions that consumers make when prices rise. For example, if the cost of cupcakes increases, consumers may buy cookies instead, a less expensive dessert option. They may also buy a smaller package, switch to a cheaper brand, or shop at a discounted store to save money. The government's inflation calculation method now factors in these behaviors, which helps to provide a more accurate measure of inflation. However, some critics argue that this method still has limitations. For instance, product swaps may be made between entirely different categories, such as buying chicken instead of steak, when the price of the latter increases. This can make it challenging to measure inflation accurately across various product categories.

Starting in February, the BLS will make two changes to the CPI methodology. The first change will involve updating the CPI weights annually based on a single year of data. Previously, the BLS revised CPI weights every two years using two years' worth of expenditure data. With the new method, the weights will be updated annually based on a single year of data. This change is set to take effect with releasing the CPI data for January 2023, which is scheduled to be published in February 2023. The difference in methodology will also introduce an improvement to the time series filter used to estimate the most recent cyclical trend and short-term fluctuations for the CPI of “new vehicles”. This improvement is expected to enhance the accuracy of the index by providing a better representation of price changes over time. This move is expected to benefit both economists and consumers alike. By updating the CPI weights annually, the index will better reflect the changing spending habits of consumers and the prices of goods and services they purchase. This will help provide a more accurate measure of inflation, essential for policy decisions and assessing the economy's health.

The second change comes from the new vehicles index. The new vehicles index is an essential component of the CPI, as it is included in the transportation group. Along with the index for used vehicles, it makes up the new and used motor vehicles index. The new vehicles index is published at the U.S., region, division, and local levels, providing information on the cost of purchasing new cars and trucks in different parts of the country. The new vehicles index comprises subcompact, compact or sporty, intermediate, full, luxury cars, pickup trucks, vans, and specialty vehicles. Specialty vehicles include sport and cross-utility vehicles. The prices for these vehicles are estimated using a transactions dataset purchased from J.D. Power that provides for observed transaction-level prices and detailed vehicle information. Each observation in the dataset includes a transaction price and a set of 40 variables, such as rebate values and vehicle characteristics. To calculate the index, sales tax rates are applied by the BLS. The BLS replaces the old model with the new one when the dollar sales of the new model are 50 percent or more of the total sales for the vehicle over the past 30 days, a rule known as “the 50 percent rule.” New models may be introduced anytime during the year, but they are most often introduced in the fall and generally reflected in the CPI from September through February. The change in methodology is expected to provide a more accurate estimate of the cost of new vehicles and improve the understanding of inflation trends in the U.S. economy. The BLS released revised data for the CPI for December, showing that prices rose 0.1% on a seasonally adjusted basis from November, contrary to the previously estimated decline of 0.1%. The newly calibrated data also includes adjustments for the entire year of 2022, showing that most months saw slightly lower inflation than initially reported.

In conclusion, the Bureau of Labor Statistics has announced several changes to the calculation and methodology of the CPI to improve its accuracy and usefulness. Starting with the release of the January 2023 CPI data, the BLS will switch to yearly weights based on a single calendar year of data. In addition, the CPI for new vehicles will introduce a methodology improvement to the time series filter that estimates the most recent cyclical trend and short-term fluctuations. These changes will significantly impact how inflation is measured and monitored in the United States and help provide a more accurate picture of price movements and consumer behavior. Therefore, traders and Economists will closely monitor tomorrow's CPI report, which will mark the beginning of the switch to yearly weights, to assess these changes' impact on the overall inflation picture.

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