Question

Explain the two reasons for the CPI overstating the cost of living inflation? What has the Bureau of Labor Statistics done to correct this overstatement?

Answer 1

The Bureau of Labor Statistics (BLS) produces the Consumer Price Index (CPI). It is the U.S. inflation rate indicator most commonly known and used. This is also used for the classification of the true gross domestic product (GDP). From an investor's viewpoint, the CPI as an inflation index is a vital metric that can be used to calculate, on a nominal basis, the total return expected by an investor to achieve its financial goals.

There has been debate over several years over whether inflation is overstated by the CPI or understated, how it is calculated, and whether it is a good indicator for inflation. One of the main reasons for this argument is that economists are specific about how they think inflation should be measured.

Over the years, several changes have been made to the methods used to measure the CPI. The reforms eliminated prejudices, according to the BLS, which led the CPI to overestimate the rate of inflation. The new methodology takes into consideration improvements in product performance and replacement. Substitution, the shift in consumer purchases as a result of price changes, changes the relative weighting of the basket products. Generally, the overall result is a lower CPI. Conservatives, however, interpret the methodological changes and the move from a COGI to a COLI as a purposeful manipulation that enables a lower CPI to be published by the US government.

Inflation rate also influences shareholder efficiency and analyst estimation as they assess portfolio returns. Investors should nominally measure their maximum necessary return rate (RRR) taking into account the inflation effect. As the rate of inflation rises, it is important to earn higher nominal returns to achieve a desired real return price. The estimated annual total return required is approximated as the actual return expected plus the inflation rate. The estimated method works well for small investment horizons.

Quality Adjustment Bias: Statisticians in government also face difficulties in assessing improvements in product performance. For example, if an air-conditioner's design is so improved that it can bring in 10 percent more cold air without increased energy usage, then 10 percent increase in air-conditioner prices should not be viewed as inflation.

But they also gain 10% more potential for cooling. Government statisticians, however, frequently fail to take into account the air-conditioner's improved quality and merely mention the 10 percent price increase, the price rise will be wrongly viewed as deflation. For some goods, quality assessment (as in the case of services) is very difficult. Of example, due to the availability of 24-hour cash machines, we do not know to what extent (in percentage terms) the quality of banking service has increased. Inflation will be overestimated to the degree that the CPI fails to account for quality improvements in the use of goods and services by individuals. These overestimation is known as the correction of value

Substitution Bias

CPI as a true measure of inflation is another issue. The problem arises if customers show replacement bias. Suppose consumers like mutton and fish are nearly equal and eat equal quantities of each in the base year. But the price of mutton increases dramatically for some reason, which encourages consumers to eat only fish. Consequently, the cost of living is not greatly affected by mutton's price rise.

It does not take note of the fact that customers often substitute more costly products or services with.cheaper. This cause of true inflation overestimation is called the replacement bias.

Introduction of New Products

When businesses sell new products with high prices, the CPI will go up. This is another reason why inflation is calculated by the CPI over.

If CPI overestimates actual inflation, then rises in real atypical family income (which is the true purchasing power indicator) are underestimated correspondingly. Industrial workers ' salaries are often related, as determined by the CPI, to the cost of living indices in order to protect workers ' living standards in the organized sector.