Consumer Price Index: More Frequent Updating of Market Basket Expenditure
Weights Is Needed (Letter Report, 10/09/97, GAO/GGD/OCE-98-2).

The "market basket" of goods and services used to track changes in the
Consumer Price Index (CPI) is revised about once every 10 years. Items
in the CPI include housing, transportation, food, clothing, medical
care, and entertainment. Updating the market basket between major
revisions would yield a more accurate CPI. The cost to update the market
basket would be significantly less than the cost of a major revision.
The Bureau of Labor Statistics (BLS) estimates that updating the market
basket in 2003 would cost about $3.1 million. In contrast, BLS will
spend about $66 million on the 1998 revision. Moreover, because federal
tax brackets and payments are indexed to the CPI, a more accurate CPI
could have a positive impact on the federal budget deficit.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD/OCE-98-2
     TITLE:  Consumer Price Index: More Frequent Updating of Market 
             Basket Expenditure Weights Is Needed
      DATE:  10/09/97
   SUBJECT:  Price indexes
             Economic indicators
             Economic policies
             Statistical data
             Economic analysis
             Inflation
             Cost of living
             Future budget projections
             Budget deficit
             Foreign governments
IDENTIFIER:  Consumer Price Index
             BLS Consumer Expenditure Survey
             Dept. of Commerce Personal Consumption Expenditures Data
             Gross Domestic Product
             Japan
             Italy
             Germany
             France
             United Kingdom
             
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Cover
================================================================ COVER


Report to the Ranking Minority Member, Committee on Banking and
Financial Services, House of Representatives

October 1997

CONSUMER PRICE INDEX - MORE
FREQUENT UPDATING OF MARKET BASKET
EXPENDITURE WEIGHTS IS NEEDED

GAO/GGD/OCE-98-2

Market Basket Expenditure Weights

(410072)


Abbreviations
=============================================================== ABBREV

  BEA - Bureau of Economic Analysis
  BLS - Bureau of Labor Statistics
  CBO - Congressional Budget Office
  CEA - Council of Economic Advisers
  CEX - Consumer Expenditure Survey
  CPI - consumer price index
  CPI-U - consumer price index representing all urban consumers
  CPI-W - consumer price index representing all urban wage and
     clerical workers
  GDP - gross domestic product
  OMB - Office of Management and Budget
  PCE - Personal Consumption Expenditures
  POPS - Point-of-Purchase Survey
  SSA - Social Security Administration

Letter
=============================================================== LETTER


B-275450

October 9, 1997

The Honorable Henry B.  Gonzalez
Ranking Minority Member
Committee on Banking and Financial Services
House of Representatives

Dear Mr.  Gonzalez: 

The principal source of information on trends in consumer prices and
inflation in the United States is the Consumer Price Index (CPI),
according to the Bureau of Labor Statistics (BLS), which publishes
the index.\1 In fiscal year 1996, about $656 billion of federal tax
receipts and $458 billion in federal spending were automatically
linked to price changes measured by the CPI.  The CPI tracks prices
for a fixed "market basket" of goods and services that people buy for
day-to-day living.  Since 1940, BLS has made major revisions to the
market basket about once a decade to reflect changes in what
consumers buy.\2

This report responds to your request that we examine certain
questions surrounding the issue of revising the market basket more
often.  As agreed with your office, rather than evaluating possible
alternatives to the CPI's basic formula or examining the whole
process of making major revisions to the CPI,\3 we focused on the
market basket's expenditure weights and whether they could be updated
between major revisions to the CPI.\4 Historically, the expenditure
weights have been changed only during major CPI revisions.  Unlike in
a major revision, the principal task in an update would be to
change--make more current--the expenditure weights that had been
determined during the last major revision.  In a revision, BLS has
usually changed (1) the CPI's geographic areas and housing samples,
which reflect where consumers live and buy goods and services; (2)
the computer systems for processing these data; and (3) the
expenditure weights of the market basket items.  (App.  II provides
additional information on how the CPI is constructed and on how
weights are calculated.)

As agreed more specifically, we focused on the market basket's
expenditure weights by (1) obtaining the views of individuals who
were knowledgeable of the CPI on updating the weights between major
revisions to the CPI and the practices followed by other
industrialized countries in updating their consumer price indexes,
(2) estimating the additional cost to BLS to update the weights on a
5-year cycle,\5 (3) estimating the dollar effect on the federal
budget if the weights were updated on a 5-year cycle, and (4)
identifying and assessing BLS' reasons as to why updates of the
weights have only occurred during major revisions to the CPI, which
have been about every 10 years. 


--------------------
\1 BLS is a part of the U.S.  Department of Labor. 

\2 There has not been a uniform number of years between major
revisions to the CPI's market basket.  Although a revision was made
each decade, the number of years between revisions ranged from 9
years to 14 years for the four revisions that occurred since 1940. 

\3 A commission chartered by the U.S.  Senate has proposed an
alternative formula that is intended to make the CPI more reflective
of the cost of living.  We present information later in this report
about the alternative, which is referred to as a superlative index. 

\4 Weights allow BLS to specify the importance of the items included
in the CPI market basket and provide appropriate emphasis to the
price changes associated with those items.  For example, if ground
beef were assigned a weight representing about one-third of 1 percent
of the expenditures of the typical urban consumer and if sirloin
steak were assigned a smaller weight representing less than one-tenth
of 1 percent, then the price changes of ground beef would have about
3 times as much impact on the overall CPI as similar price changes
for sirloin steak. 

\5 The Price Statistics Review Committee suggested, in 1961, that the
more volatile categories of the market basket's expenditure weights
be updated at 5-year intervals.  This committee was formed under a
contract between the Bureau of the Budget--the predecessor of the
Office of Management and Budget--and the National Bureau of Economic
Research.  Although more than 35 years have passed, the committee's
work is still recognized as an important study of the CPI. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

The weight of professional opinion supported updating the market
basket's expenditure weights more frequently than major revisions to
the CPI have been made.  We spoke with 10 individuals who were
knowledgeable about the CPI, and they were unanimous in believing
that 10 years between updates was too long to reflect "current"
consumer spending.  Two of the 10 individuals were former BLS
officials, and the 8 others had conducted research on the CPI,
including 4 who were members of the Advisory Commission to Study the
Consumer Price Index (hereafter called the Boskin commission).\6

There was less agreement among the 10 individuals, however, on
exactly how often updates should occur.  Five of them, including the
four Boskin commission members with whom we spoke, said more frequent
updating of expenditure weights was less important than other ways of
making the CPI more reflective of current consumer spending. 

Other major industrial countries update their consumer price indexes
more often than the United States, according to information provided
by BLS and contained in international publications.  Of the six
industrial countries that together with the United States have made
up the Group of Seven countries (G-7),\7 two updated the weights of
their consumer price indexes annually, and the other four did so
approximately every 5 years.  However, BLS officials noted that some
of these countries based their updates on national data that are not
comparable to data used by the United States; for example, some
countries have not collected expenditure data directly from
consumers. 

The cost of updating the expenditure weights is significantly less
than the cost of a major revision.  For the purposes of estimating
costs in this report, we assumed that an update to the expenditure
weights would occur in 2003, which would be 5 years after the planned
revision in 1998.  BLS estimated that the cost to update the weights
in 2003 would be about $3.1 million.  In comparison, BLS estimates
that it will spend about $66 million on the upcoming 1998 revision. 

Because federal tax brackets and federal payments, such as those to
Social Security beneficiaries, are adjusted for inflation, a CPI that
more accurately measures inflation could affect the federal budget. 
BLS estimated the range of change in the CPI, if the expenditure
weights were updated on a 5-year cycle, from 0 (zero)--no change--to
a decrease of 0.2 percentage point.  We asked the Congressional
Budget Office (CBO) to use the midpoint of BLS' range (0.1 percentage
point) to estimate the effect on the federal budget.  CBO estimated
that, assuming no other changes in policy or economic assumptions, if
updating the weights in 2003 (5 years after the planned 1998
revision) reduced CPI growth by 0.1 percentage point annually, the
projected budget surplus would be increased by a cumulative total of
$10.8 billion over the 4-year period of 2004 through 2007. 

BLS cited several reasons for not updating the expenditure weights
between major CPI revisions.  The foremost reasons, according to BLS,
were a lack of empirical evidence to support more frequent updates
and a void of theoretical guidance on how often to do them.  BLS'
other reasons were difficulties in obtaining funds to bring about
change to the CPI and concern with what would be the best approach to
improve the CPI.  In the past, data availability was also cited as a
reason, but data collection improvements have since addressed this
problem. 

Although theoretical guidance is not available on all facets of
updating expenditure weights, such as exactly how often updates
should occur, the preponderance of the data we reviewed supports the
need for updating expenditure weights more frequently than about
every 10 years.  Recognizing that the data are not perfect and do not
isolate the effects of using outdated expenditure weights,
comparisons of price indexes with old and new weights that go back to
those made for the first revision in 1940 indicate that price indexes
computed with more current weights were always different from indexes
computed with older weights.  In addition, these comparisons and more
recent research conducted by BLS tend to show lower rates of
inflation with indexes using newer weights. 

BLS' concerns about updating the expenditure weights between major
revisions were indicated in June 1997, when BLS officials said that
BLS has the technical ability to update the expenditure weights, but
it must work through the challenging issues that now surround the CPI
program.  In August 1997, the BLS Commissioner said, in commenting on
a draft of this report, that she supports updating the expenditure
weights more frequently and that BLS was in the process of developing
a new updating policy.  As part of the process of developing this
policy, the Commissioner said BLS was studying a number of related
practical questions and would seek the advice of its advisory
councils. 


--------------------
\6 The Advisory Commission to Study the Consumer Price Index was
chartered by the U.S.  Senate.  The five-member advisory commission
issued a report, in December 1996, to the Senate Committee on Finance
titled Toward a More Accurate Measure of the Cost of Living.  The
advisory commission was chaired by Michael J.  Boskin, and it was
referred to as the Boskin commission. 

\7 The United States, Japan, Italy, Germany, France, Canada, and the
United Kingdom have made up the G-7 countries that have met to
coordinate economic and monetary policy. 


   BACKGROUND
------------------------------------------------------------ Letter :2

The CPI measures the change in prices of a fixed market basket of
goods and services purchased directly by urban consumers.  These
purchases are for food, clothing, shelter, fuels, transportation,
medical care, entertainment, and other goods and services that people
buy for day-to-day living.  Only expenditures made by consumers are
captured in the CPI. 

The CPI is used by the federal government, businesses, labor
organizations, and private citizens.  According to BLS, the CPI is
used as an economic indicator of inflation; an escalator for wages,
income payments, and tax brackets; and a deflator of selected
economic statistical series.  For example, through collective
bargaining contract negotiations in 1996, 1.7 million workers had
their wages raised on the basis of changes in the CPI.  As a result
of changes in prices as reported in the CPI in 1996, 43.5 million
Social Security beneficiaries\8 and 25.8 million food stamp
recipients had their benefits increased for inflation in 1996. 

According to BLS, to construct the CPI, the prices of more than
94,000 items are collected each month (e.g., margarine sold in tubs,
sticks, or squeeze bottles) and aggregated into 206 "item strata"
(e.g., fats and oils).  In making the monthly calculations, according
to BLS, weights are used to give proportionate emphasis for price
changes of one item in relation to other items in the CPI. 

According to BLS, two sets of weights are computed from different
sources of information.  BLS computes one set of weights from the
Consumer Expenditure Survey (CEX) data.  These weights, which are the
focus of this report, are used to aggregate the 206 item strata into
the overall index number for the CPI.  In this report, we refer to
this first set of weights as "expenditure weights."

The second set of weights is derived primarily from information taken
from the Point-of-Purchase Survey (POPS).\9 These weights, which we
term "point-of-purchase weights" in this report, are used to combine
the prices of the 94,000 items into the 206 item strata.  In other
words, the point-of-purchase weights are used to aggregate the prices
of the individual items into the 206 item strata and provide the base
to which the expenditure weights are applied to calculate the CPI. 

The two sets of weights are updated at different time intervals.  BLS
began to publish the CPI regularly in 1921 and has changed
expenditure weights only when making major revisions to the CPI. 
These major CPI revisions occurred in 1940, 1953, 1964, 1978, and
1987; another revision is scheduled for 1998.\10 BLS instituted the
POPS in 1978.  All of the point-of- purchase weights are scheduled to
be updated over a 5-year period, according to BLS. 

The CPI is often referred to as a cost-of-living index and is used to
reflect the cost of living to adjust, for example, federal income tax
brackets and some federal payments.  Although some elements of the
CPI reflect cost-of-living concepts, the CPI was not designed to be a
cost-of-living index.  As usually defined, a cost-of-living index
would be broader in coverage than an index that is based on consumer
expenditures.  BLS has said through the years that the CPI is not a
cost-of-living index.  To date, the federal government has not
developed a comprehensive cost-of-living index.\11

In 1961, the Price Statistics Review Committee (hereafter called the
Stigler committee for its chairman, George Stigler) recommended that
the conceptual framework of the CPI be modified to represent a
cost-of-living index.  It also supported comprehensive revision of
CPI weights at least once every decade and suggested that the more
volatile categories of CPI weights be updated at least once every 5
years.  The BLS Commissioner in 1961 agreed that the CPI should be
revised every 10 years.  Although the Commissioner agreed with the
suggestion to update CPI weights more often, he cited some obstacles
that he thought, at the time, would preclude BLS from doing so.  We
discuss these obstacles later in this report in the section on BLS'
reasons for not updating expenditure weights more often. 

In reporting to Congress in December 1996, the Boskin commission said
its overarching recommendation was that BLS establish a
cost-of-living index as its objective in measuring consumer prices. 
The Boskin commission concluded that the CPI overstates inflation
because of four sources of bias:  substitution bias,\12 new products
bias, quality change bias, and new outlets bias.\13 The commission
further subdivided substitution bias into what it termed lower-level
bias and upper-level bias.  The lower-level bias concerns the
aggregation of the prices of the individual items,\14 and the
upper-level bias concerns the 206 item strata, which are the subject
of this report. 

To address upper-level substitution bias, the Boskin commission
recommended that the fixed market basket CPI be abandoned and
replaced with two new formulas that would enable the CPI to more
closely reflect the cost of living.  One formula, according to the
commission Chairman, would be a true superlative index; the other
formula would be a modified superlative index.\15 A superlative
index, by definition, would continually change the market basket to
reflect current consumer spending.\16 BLS has requested funding for
fiscal year 1998 to continue the fixed market basket CPI and to
publish a CPI with a superlative index formula in 2002.  Since the
fixed market basket CPI would continue to be published, the
discussion on how frequently to update the expenditure weights is
pertinent. 


--------------------
\8 Automatic adjustments of Social Security benefits, which are based
on increases in the CPI, began in 1975 (42 U.S.C.  415(i)). 

\9 The CEX is used to gather data from consumers to ascertain what
goods and services they are purchasing; the POPS is used to gather
data from consumers to find out where they shop for goods and
services.  According to BLS, it constructs weights and selects outlet
samples from sources other than the POPS for a relatively small
number of item categories. 

\10 The 1987 revision was based on CEX data collected in 1982 through
1984.  The planned 1998 revision will be based on CEX data collected
in 1993 through 1995.  In this report, we refer to the year of the
introduction of the change of expenditure weights (e.g., 1987) rather
than to the base years used to establish the weights (e.g., 1982-84). 
We are using the year of introduction as the reference point when we
refer to a 5-year update (e.g., 1992 update). 

\11 For additional information about how the CPI measures the cost of
living, see our report, Consumer Price Index:  Cost-of-Living
Concepts and the Housing and Medical Care Components (GAO/GGD-96-166,
Aug.  26, 1996). 

\12 Relative to a cost-of-living index, substitution bias gives
increasing importance to items in the CPI with higher-than-average
price increases.  For example, this bias occurs when consumers
purchase cheaper chicken for beef when the price of beef rises.  In
this illustration, the CPI overstates inflation because it continues
to track the price of beef, which consumers would have no longer
purchased, rather than the price of chicken, which consumers would
have substituted for beef.  A downward bias can also occur when
consumers are driven to purchase more expensive substitutes, which
can occur, for example, during wars and mandatory price controls. 

\13 The Boskin commission estimated that the CPI overstated inflation
by 1.1 percentage point.  The commission attributed 0.4 percentage
point to substitution bias, 0.6 to new products and quality change
biases, and 0.1 to new outlets bias. 

\14 In April 1997, BLS began publishing an experimental CPI that
addresses the lower-level substitution bias by using a different
formula to aggregate the 94,000 individual items into the 206 item
strata. 

\15 The Boskin commission's report did not use the term "modified"
superlative index.  However, in our discussion with the Chairman, he
agreed that one formula was not a true superlative and could be
referred to as a modified superlative index.  We use this term
throughout this report. 

\16 A superlative index formula is described in appendix IV.  The CPI
is constructed with another formula, which holds the market basket of
goods and services constant until a revision or update of the
expenditure weights.  That formula is described as well in appendix
IV. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :3

To obtain opinions on updating the CPI expenditure weights more
often, we asked two former BLS officials and eight others who were
knowledgeable about the CPI how often the weights should be updated. 
The eight other individuals had conducted research in connection with
the CPI:  four of the eight individuals were members of the Boskin
commission, two were academicians, one was employed by a major
economic research institution, and one was a member of the Stigler
committee.  (App.  I describes how we selected these eight
individuals.) To obtain information on the practices followed by
other industrialized countries in updating their consumer price
indexes, which also addresses our first objective, we obtained
information from BLS and from publications of the Organization for
Economic Cooperation and Development and the Canadian government on
how often G-7 countries update their CPIs. 

To estimate the cost to BLS of updating the expenditure weights for
the CPI on a 5-year cycle, we asked BLS to provide us with certain
actual and estimated cost data.  We asked BLS to provide us with the
costs associated with the 1987 revision and the projected costs for
the 1998 revision.  In addition, we asked BLS for its estimate of
what the costs would have been to update the CPI in 1992 and its
estimate of what the cost might be to update the CPI in 2003.  We did
not specify to BLS what assumptions to make or what items to include
or exclude in estimating the costs for 1992, 1998, and 2003.  We also
did not evaluate the reasonableness of BLS' assumptions or estimates. 
BLS provided us with costs for the 1987 revision and estimated costs
for the 1998 revision and a 2003 update of the CPI.  BLS suggested
that the cost for a 1992 update could be derived by deflating the
cost of the 2003 update, which we did with the Gross Domestic Product
(GDP) price index.\17

To estimate the dollar effect on the federal budget if the
expenditure weights for the CPI were updated on a 5-year cycle, we
obtained assistance from BLS and CBO, which analyzes budget-related
issues and provides cost estimates for legislative proposals to
Congress.  We asked BLS to provide a range--an upper percentage point
and a lower percentage point--of the possible change that would occur
to the CPI with a 5-year update. 

We asked CBO to estimate the effect that a 5-year update of the CPI
would have on the federal budget, assuming no other changes in tax or
spending levels and no other changes in the economy.  To do this, we
asked CBO to use BLS' lower and upper estimates of change and the
midpoint of these estimates.  To illustrate the effect of a 5-year
update that would begin in 2003, we asked CBO to make projections for
the years 2003 through 2007 as it normally would and then to do a
reestimation after adjusting for the effects of a 5-year update.\18

CBO's policy is to provide projections for current and future years,
but not to provide estimates for past years.  For that reason, we
estimated how the federal budget might have been affected if the
expenditure weights had been updated in 1992, which was 5 years after
the 1987 major revision.  In making our estimates, we used CBO's
estimates for 1998 through 2007 to backcast to 1992.  In doing so, we
assumed that the trend that was used for the years 1998 through 2007
could be reasonably applied to the years 1993 through 1998.  We
discussed the methodology we used in making the estimates with CBO
officials, and they said that the methodology we used and the results
we obtained were reasonable. 

In connection with impact on the federal budget, as requested by your
office, we asked the Chief Actuary of the Social Security
Administration (SSA) to estimate the effect a change in the CPI would
have on the average benefit paid to retired workers.  To make the
estimate, we asked SSA to use the midpoint of BLS' range of possible
change that would occur to the CPI with a 5-year update.  Using that
midpoint percentage point and economic assumptions used in the
President's Fiscal Year 1998 Budget, SSA estimated the change in the
average monthly benefit check for retired workers, beginning with
December 2003, which would be payable in January 2004, and continued
through December 2007. 

To identify and assess why updates to the CPI weights have been
spaced 10 years or so apart since 1940, we talked with present and
past officials of BLS and obtained their views on the reasons for
this spacing.  We also reviewed the 1961 congressional testimony of a
BLS Commissioner in which he addressed the subject of BLS' timetable
for revising the CPI.  In our assessment, we (1) collected and
analyzed information on past comparisons between indexes that applied
old and new expenditure weights, (2) obtained information on how BLS
collects its source data for the CPI, (3) reviewed BLS budget
information to ascertain BLS' plans for future changes in its
indexes, and (4) compared the estimated costs and benefits of a
5-year update to place an update in practical perspective. 

In our assessment, most of the comparisons between indexes with old
weights and indexes with new weights probably reflected differences
that were not due to changes in the expenditure weights alone.  Some
of the indexes we used were produced by BLS for "overlap" periods. 
When major revisions to the CPI were made, BLS calculated two indexes
for several months.  One index used the weights that had been in
effect before the revision, and the second index used the new weights
that were created for the revision.  However, during a revision, many
factors can and do change.  For example, the geographic locations
where data are collected are changed to some extent as are the items
of goods and services in the market basket.  Therefore, the
differences that may result from comparing the two indexes may be due
to several factors, and the effects of changes to the expenditure
weights cannot be isolated from the effects of other changes to the
index data. 

With this knowledge, we treat the differences as indicators of the
effects of an update of the expenditure weights because an update of
the weights is unlikely to occur in isolation from the other factors
that are associated with revisions.  For example, a 1992 update would
have most likely incorporated a market basket that was based on
different geographic areas than the areas that were used in the 1987
revision because, in 1986, changes were made in the geographic
locations where expenditure data were collected.  Such geographic
changes are associated with major revisions. 

In addition to overlap studies, we examined the effect of the age of
weights with indexes that were calculated with alternative base-year
periods.  For example, comparisons were made of the official CPI's
3-year base of 1982 through 1984 with alternative 3-year base periods
(i.e., 1987 through 1989).  In these and other comparisons, we
applied an economic concept that is based upon economic literature
that suggests that an index is more accurate if the expenditure
weights used to compute it represent, as much as practical, current
consumer spending.\19 However, in our review of economic literature,
we did not identify any theoretical guidance on how often (e.g., 5
years as compared with 10 years) expenditure weights should be
updated.  (See app.  I for more information about our objectives,
scope, and methodology.)

As previously reported in this section, this report includes, and
often relies on, estimates and comparisons prepared by BLS, CBO, or
SSA.\20 We did not verify the computerized data that the agencies
used in producing these estimates and comparisons.  Verification, in
our opinion, would have been impractical because it would have been
costly and time consuming.  In addition, the estimates and
comparisons were within the scope of activities that BLS, CBO, and
SSA normally perform.  Therefore, we used their estimates and
comparisons. 

The results we obtained are intended to contribute to the discussion
of how often the CPI should be updated, but they are not intended to
represent all future effects of shortening the updating cycle. 
Neither is our work intended to evaluate a change in the basic
formula that could address substitution bias in the CPI.  The point
of shortening the updating cycle would be to have the CPI reflect, as
closely as practical, the current spending patterns of consumers,
regardless of whether the index is pushed upward or downward. 

We did our work in Washington, D.C., between November 1996 and July
1997 in accordance with generally accepted government auditing
standards.  We requested comments on a draft of this report from the
Secretary of Labor, the Chair of the Council of Economic Advisers
(CEA), the Director of the Office of Management and Budget (OMB), and
the Chair of the Board of Governors of the Federal Reserve System or
their designees.  Comments by BLS, CEA, OMB, and the Federal Reserve
are discussed near the end of this letter and are reproduced in
appendixes V through VIII. 


--------------------
\17 The GDP price index, which is determined by the Bureau of
Economic Analysis of the Department of Commerce, can be used to
adjust dollar amounts into inflation-adjusted dollars. 

\18 CBO made projections for 1998 through 2007, which is a 10-year
period.  CBO does not make projections beyond a 10-year time frame. 
In estimating the effects of a CPI update on the federal budget, CBO
reduced its projected rate of inflation, as measured by the CPI, by
the lower and upper estimates provided by BLS and by the midpoint of
that range. 

\19 For example, see Jack E.  Triplett, "Economic Theory and BEA's
Alternative Quantity and Price Indexes," Survey of Current Business,
Vol.  72 (Apr.  1992), pp.  49-52; Ralph Turvey, Consumer Price
Indexes:  An ILO Manual (Geneva:  International Labor Office, 1989),
p.  38; and Price Statistics Review Committee, The Price Statistics
of the Federal Government:  Review, Appraisal, and Recommendations, A
Report to the Office of Statistical Standards, Bureau of the Budget
(New York:  National Bureau of Economic Research, 1961), p.  31. 

\20 BLS estimated (1) the cost to update the expenditure weights and
(2) the range of percentage effect on the CPI if the expenditure
weights were updated at 5-year intervals.  BLS also provided us with
its past comparisons of old-weighted and new-weighted indexes.  CBO
estimated the dollar effect on the federal budget if CPI growth were
lowered 0.1 percentage point or 0.2 percentage point annually.  SSA
estimated the impact on Social Security payments if the CPI were
reduced annually by 0.1 percentage point. 


   MORE FREQUENT UPDATING IS
   DEEMED DESIRABLE BY INDIVIDUALS
   KNOWLEDGEABLE OF THE CPI THAT
   WE CONTACTED
------------------------------------------------------------ Letter :4

We spoke with 10 individuals who were former officials of BLS or who
had otherwise studied the CPI, and they were unanimous in stating
that 10 years between updates of the expenditure weights was too
long.  However, there was less agreement among the individuals on
exactly how often the updating should occur.  According to
information obtained from BLS and international publications, seven
major industrial countries have consumer price indexes but, among
them, only the United States updates its CPI as infrequently as once
a decade. 


      PROFESSIONAL OPINIONS ON
      UPDATING
---------------------------------------------------------- Letter :4.1

Two former BLS officials told us that updating the weights about
every 5 years was about right.  One official told us that the POPS
should be rotated more frequently, which would affect
point-of-purchase weights.  He also advocated a different method of
aggregating CEX data to develop the expenditure weights for the 206
item strata.  The other former official, a previous BLS Commissioner,
noted that doing an update more frequently than every 5 years would
be too often. 

We also spoke with a former member of the Stigler committee and four
members of the Boskin commission.  The former Stigler committee
member said that updating the CPI only every 10 years was entirely
too infrequent.  However, he gave low priority to updating the
expenditure weights more often because he believed that getting new
consumer items into the CPI and accounting for product improvement
were more important.  The four members of the Boskin commission also
said that the expenditure weights for the market basket should be
updated more frequently than every 10 years.  However, the members
regarded more frequent updating as only one step to improving the
CPI.  The Boskin commission recommended abandoning the fixed market
basket aspect of the CPI and adopting a true superlative index
formula and a modified superlative index formula to account for
changing market baskets. 

The spirit of the Boskin commission's recommendations, according to
its Chairman, was for the CPI to be more current in order to reflect
what is occurring in the economy.  He said that if there were no
change in existing products or no new products in the economy, then
updating the expenditure weights would be the only step that would
need to be taken.  However, the economy is changing, with new
products and product improvements occurring constantly.  Therefore,
more frequent updating was only a step toward what should be done to
improve the CPI.  He said BLS should be in a permanent revision mode. 
Because different aspects of the CPI interact with each other, a
change in the expenditure weights would complement other steps that
could be taken, such as changing the POPS sample more often than
every 5 years, increasing the size of the CEX, and using estimation
methods to adjust for changes in the quality of items in the CPI. 

Two of the three remaining members of the Boskin commission with whom
we spoke told us that the expenditure weights should be updated more
frequently than every 5 years.  The other member, citing concern
about resource constraints faced by BLS, gave preference to providing
financial support to implement the Boskin commission's
recommendations to improve the CPI, rather than funding a more
frequent update of the market basket. 

The remaining three individuals we spoke with also supported a more
frequent update than about every 10 years as a more accurate way to
track inflation.  One of them said that doing so would not
necessarily lead to lower measures of inflation. 

In addition, although we did not interview the Chairman of the Board
of Governors of the Federal Reserve System, we noted that he stated
in a speech, in March 1997, that there was a bias problem in the CPI
given the failure to change the expenditure weights more often than
about every 10 years.  However, a representative of the Federal
Reserve, in commenting on a draft of this report, said that although
the Federal Reserve Chairman has said that out-of-date weights are a
source of bias in the CPI, the Chairman does not endorse merely
updating them more frequently.\21 He said that the Chairman has
testified before Congress in support of changes recommended by the
Boskin commission, and that the payoff of departing from a
fixed-weight structure of the CPI is likely to be much more important
in improving the accuracy of the CPI than more frequent updating of
expenditure weights alone. 


--------------------
\21 These comments were made by the Assistant Director and Chief,
Economic Activity Section, Division of Research and Statistics, the
Federal Reserve System.  His comments are reprinted in appendix VIII. 


      PRACTICES OF OTHER
      INDUSTRIAL COUNTRIES
---------------------------------------------------------- Letter :4.2

As previously mentioned, the United States is one of the seven
leading industrial countries--the G-7--that have met to coordinate
economic and monetary policy.  In addition to the United States, the
other six G-7 countries also track consumer prices through a market
basket of goods and services and weight the prices of the items in
the market basket.  According to a BLS official and published
information, Japan and Italy update expenditure weights every 5
years; Germany updates, on average, about every 5 years; Canada
updates every 4 years--except for the last update (6 years), when it
reengineered its index; and France and the United Kingdom update
every year. 

However, BLS officials noted that some of these countries base their
updates on national data that are not comparable to the U.S. 
continuing CEX.  Some of the countries do not use expenditure data
collected directly from consumers; others use consumer expenditure
data that require respondents to recall 12 months of expenditure
data.  BLS officials said the system used in the U.S.  CPI for
maintaining current and representative samples of items to price is
more advanced than in most other countries. 

We are not endorsing the practices in any other country over BLS'
practices.  We provide this information for comparative purposes to
show the priority other countries place on keeping their market
baskets current. 


   COST TO UPDATE THE EXPENDITURE
   WEIGHTS IS ESTIMATED TO BE
   RELATIVELY SMALL
------------------------------------------------------------ Letter :5

The estimated cost of updating expenditure weights is relatively
small in comparison to the cost of major revisions.  For the purposes
of estimating costs, we assumed in this report that updates of
expenditure weights would occur in 1992 and 2003, which is 5 years
after major revisions.  On the basis of data supplied by BLS, the
estimated cost to have updated the weights in 1992 would have been
$2.4 million spread over 3 years.  According to BLS, the estimated
cost to update the expenditure weights in 2003 would be $3.1 million
over a 3-year budget period.  BLS reported that the 1987 major
revision cost $47 million over 5 years.  According to BLS, the cost
for the planned 1998 revision is expected to be about $66 million
over 6 years. 

BLS noted that the estimated cost of an update excluded many
activities that were included in the costs for revisions to the CPI. 
These excluded activities include using recent decennial census data
to reselect geographic areas and housing samples used in the CPI's
surveys; evaluating, replacing, and updating CPI data processing
systems; and recategorizing the items in the CPI market basket.  The
activities that BLS included in its estimated cost to update the
expenditure weights included changing the weights of the items in the
market basket, redefining the item strata in a limited way, and
including any new items as a result of the limited redefinition of
the item strata.  For example, the costs of an update might include
those associated with adding an item stratum for cellular telephone
services.\22


--------------------
\22 BLS officials told us that they plan to add this stratum in the
upcoming 1998 revision. 


   MORE FREQUENT UPDATES COULD
   AFFECT THE FEDERAL BUDGET
------------------------------------------------------------ Letter :6

Because the CPI is used to index federal income tax brackets and
certain federal spending, changes in the CPI can affect the federal
budget.  BLS, at our request, estimated the impact on the CPI if the
expenditure weights were updated on a 5-year cycle, and, with the
help of CBO, we used those estimates and their midpoint to illustrate
the effect that updating might have on the federal budget.  In making
these estimates, both we and CBO assumed that there were no other
changes in tax or spending levels and no other changes in the economy
during the periods under review. 

BLS said the historical evidence suggests that shifting to a 5-year
update of the market basket weights could reduce the annual rate of
growth of the CPI by between 0 (zero) and 0.2 percentage point. 
Although CBO does not backcast, using a method discussed with it, we
estimated that an update in 1992 would have reduced the federal
budget deficit between $0 and $32.4 billion over the 6-year period
until the implementation of the upcoming 1998 revision.  According to
CBO, an update in 2003 could increase the projected budget surplus
between $0 and $20.2 billion over a 4-year period. 

Using estimates provided by CBO for an annual 0.1 percentage point
reduction in CPI growth and assuming no other changes in policy or
the economy, we estimated that the federal deficit would have been
reduced by a cumulative total of $16.2 billion over the 6 years
following an update in 1992.  According to CBO, an update in 2003 in
which CPI growth would be reduced annually by 0.1 percentage point
and assuming that nothing else changed, the projected federal budget
surplus would be increased by a


cumulative total of $10.8 billion over the 4 years following the
update.\23 As shown in figure 1, most of the impact of such a
reduction in the CPI would be on federal outlays--such as reduced
payments to Social Security beneficiaries, which account for most of
the outlays--and most of the impact would occur in the later years. 
For example, according to estimates by SSA's actuaries, the average
monthly benefit check for retired workers in 2004 would be reduced by
$0.91, from $939.94 to $939.03, with an annual 0.1 percentage point
reduction in CPI growth; by the fourth year (2007), the average
monthly check would be reduced by $3.83, from $1,032.56 to
$1,028.73.\24

   Figure 1:  Estimated Increase
   in Annual and Cumulative
   Federal Budget Surplus if CPI
   Growth Were to Be Reduced
   Annually by 0.1 Percentage
   Point Over a 4-year Period
   After a 2003 Update

   (See figure in printed
   edition.)

Note:  The estimates assume no other changes in tax or spending
levels and no other changes in the economy. 

Source:  CBO. 


--------------------
\23 To compare the midpoint estimates, we converted them to 1997
constant dollars.  The 1997 constant-dollar estimate of the effect of
a 1992 update on the federal budget would have been a cumulative
decrease in the federal deficit of $16.4 billion over 6 years.  For a
2003 update, the effect of a 0.1 percentage point reduction in the
CPI was estimated by CBO to be an increase in the projected surplus
of $8.6 billion in 1997 constant dollars over the following 4 years. 
A constant-dollar value is measured in terms of prices of a base
period to remove the influence of inflation.  The resulting
constant-dollar value is the value that would exist if prices had
remained the same as those in the base period (e.g., 1997). 

\24 According to SSA, by the fifth year (2008), the average monthly
benefit check for retirees would be reduced by $4.86, from $1,065.98
to $1,061.12. 


   EVIDENCE SUGGESTS MORE FREQUENT
   UPDATES WOULD BE BENEFICIAL
------------------------------------------------------------ Letter :7

BLS has taken actions to respond to the 1961 Stigler committee study,
and the current BLS Commissioner told us one response in particular
enabled BLS to markedly improve the representativeness of consumer
items and prices in the CPI.  However, BLS had not acted on the
Stigler committee's suggestion to update the more volatile categories
of weights at least once every 5 years, and BLS officials cited
several reasons for not doing so.  The most important reason, they
said, was a lack of empirical evidence to support more frequent
updates and a void of theoretical guidance on how often to do them. 
The officials said that another reason was previous difficulties in
obtaining funds for major revisions of and improvements to the CPI. 
They also said that, in the past, certain data necessary to update
expenditure weights were unavailable between major revisions, but
that situation has changed.  In addition, BLS cited its concern with
what would be the best approach to improve the CPI to make it more
reflective of current consumer spending. 

We examined the information surrounding these reasons, and, aside
from the issue of funding, which is unpredictable at this point, we
concluded that the evidence suggests that more frequent updates would
be beneficial.  As of August 1997, BLS was studying how often to
update the expenditure weights. 


      BLS HAS ACTED ON MANY
      ASPECTS OF THE STIGLER
      COMMITTEE STUDY
---------------------------------------------------------- Letter :7.1

The current BLS Commissioner said BLS has implemented many of the
Stigler committee's recommendations.  In her view, the most important
Stigler committee recommendation concerned the selection for price
tracking of individual items of goods and services.  She said that in
response to the recommendation, BLS developed and began using the
POPS in 1978 to identify sales outlets, which has allowed BLS to
incorporate new items into the CPI that otherwise would not have been
incorporated until a major revision.\25 She said that under the
methodology used with the POPS, 20 percent of the outlets and items
tracked are newly selected each year, which changes the entire sample
within 5 years.  Thus, according to the Commissioner, a large part of
the reason for wanting to update weights more frequently--maintaining
the representativeness of the item and outlet samples--is already
accomplished on a 5-year rotation. 

Evaluating BLS' response to every Stigler committee recommendation
was not the purpose of this review.  But, regarding the
Commissioner's statement of making the CPI more current through the
use of the new POPS methodology, we believe that changing the
procedures used to select retail outlets and items does make the CPI
somewhat more representative of what consumers are purchasing. 
However, implementation of the POPS still does not address the
expenditure weights for the 206 item strata that remain fixed until
the entire market basket is revised.  A 5-year rotation in the POPS
does improve the CPI in terms of keeping item samples current and
introducing new goods, which also updates the point-of-purchase
weights every 5 years.\26 Even though BLS has applied a
current-is-better approach to point-of-purchase weights, it has not
applied that same approach to the expenditure weights.  Consequently,
the items in the market basket are still aggregated into the CPI with
expenditure weights that reflect outdated consumer purchases. 


--------------------
\25 Before 1978, BLS field representatives used the same item
specifications throughout the country in an attempt to price an item
meeting the detailed description.  Since the introduction of new
sampling techniques in 1978, the field representatives use a store's
sales information to select a unique item within the specified
categories for pricing.  However, once an item is selected, the field
representative is to continue to price it in that store.  For more
detailed information, see appendix II. 

\26 Although the methodology does provide improvement, five of the
individuals with whom we spoke said that even the POPS could be made
more current with more frequent rotations than every 5 years. 


      BLS' REASONS FOR NOT
      UPDATING EXPENDITURE WEIGHTS
      MORE OFTEN
---------------------------------------------------------- Letter :7.2

We spoke with the current BLS Commissioner and other current BLS
officials about the timing of major revisions and about the obstacles
to updating the weights.  We discussed the timing of major revisions
because expenditure weights only have been updated during these
revisions.  The Commissioner said she intuitively agreed that a
10-year period is long, but she was not sure what time frame was
best.  She provided several reasons for the length of time between
major revisions to the CPI and reasons why BLS was uncertain about
undertaking a weight update independent of a major revision.  As
previously mentioned, we also obtained the comments of two former BLS
commissioners.  The reasons given by these three BLS commissioners
are presented in the following subsections along with, as
appropriate, our related evaluation. 


         LACK OF EMPIRICAL
         EVIDENCE AND THEORETICAL
         GUIDANCE
-------------------------------------------------------- Letter :7.2.1

More frequent updating of the CPI weights has not been at the top of
BLS' priority list, according to the current Commissioner, who also
said that only recently has there been any systematic evidence that
inflation, as measured by the CPI, is affected by the age of
expenditure weights.\27 She also said that even this evidence is
limited and weak.  In addition, according to the Commissioner, there
is neither a theoretically "best" frequency for updating the weights,
nor any theoretical reason why more recent weights are "better."
Therefore, she said, the decision on how often to update must be made
on commonsense and cost-benefit terms. 

BLS' view that there is insufficient evidence to support more
frequent updates is long-standing.  In 1961, the then BLS
Commissioner testified before a congressional committee that there
was no evidence to support more frequent weight updates, and he cited
a need for additional research.\28

The preponderance of the data we reviewed does not support BLS'
statement, as stated currently or in 1961, that there is insufficient
empirical evidence to support the need for more frequent updating of
expenditure weights.  In his 1961 testimony, the then Commissioner
cited three studies on which he based his conclusion, and each study
covered a different group of years between 1925 and 1939.  For the
first two periods, the old weights produced less of a decline in
prices than the new weights.  For the last period, the old weights
produced more of an increase in prices than the new weights.  The
differences between the indexes produced by the old and new weights
were 0.1 percentage point, 1.2 percentage point, and 0.1 percentage
point, respectively. 

In 1953, BLS revised the CPI and updated the expenditure weights.  It
applied the new weights to January through June 1953 consumer price
data.  In response to a presidential request, BLS also applied the
weights used in the 1940 revision to the January through June 1953
price data.  The index with the old weights showed an annual
understatement of inflation of 0.5 percentage point in comparison
with the index using the new weights.  In his 1961 testimony, the BLS
Commissioner explained that the 1953 comparisons were different from
those previously described for 1925 through 1939.  The differences
that were found in the studies for the earlier years basically
reflected changes in expenditure weights.  He noted that the
comparisons for the 1953 revision reflected factors, such as changes
in cities in the CPI, in addition to expenditure weight changes. 

As shown and analyzed in appendix III, additional empirical evidence
has become available since 1961 that also indicates that the
measurement of inflation is affected by the age of the expenditure
weights.  For example, BLS estimates that when the upcoming 1998
revision is introduced, CPI growth will be lowered by 0.1 or 0.2
percentage point.  In addition, we reviewed historical data from
overlap studies in which BLS continued calculating the CPI with both
the old and new weights for 6 months following a major revision. 
Although it is impossible to identify exactly to what extent other
factors contributed to the differences, indexes produced by the old
weights overstated inflation in comparison to those indexes produced
by the new weights in the 1964 and 1987 overlap comparisons.  The
reverse was true in 1978, but that difference may have been due to a
fundamental change in BLS procedures associated with the
implementation of the POPS. 

Additional BLS studies of indexes that examine the effects of the age
of expenditure weights include comparisons of indexes that were
calculated with alternative 3-year base periods in which BLS compared
the official CPI's 3-year base period of 1982 through 1984 with
alternative 3-year periods since then.  For example, the analysis for
an update with a 1987 through 1989 base\29 averaged 0.11 percentage
point lower over a 5-year period than an index with the 1982 through
1984 base years.  As a result of our examination of these and other
BLS studies, we concluded that the best available evidence indicates
that indexes with newer weights reduce the growth of the CPI by about
0.1 percentage point per year. 

Although theoretical guidance is not available on all facets of
updating expenditure weights, such as exactly when to update,
economic literature suggests that an index is more accurate if the
expenditure weights used to compute it represent, as much as
practical, current consumer spending.  In addition, the Stigler
committee in 1961 provided a commonsense principle on when to revise
the weights:  a revision is necessary when the weight base has
changed appreciably.  On the basis of the statements of individuals
with whom we talked (see discussion of these views on pp.  11 to 13)
and the CPI weight comparisons we reviewed (previously presented in
this subsection and in greater detail in app.  III), there is
sufficient reason to believe that the weight base had changed
appreciably before major revisions to the CPI. 

The BLS Commissioner pointed to using common sense and a cost-benefit
analysis to provide guidance on how often to update the weights.  At
the time of the Stigler committee's report in 1961 and until the
early 1970s, the CPI was used in a very limited way in the federal
sector to index federal programs for the effects of inflation; the
first large income program to be adjusted with the CPI was civil
service retirement payments in 1962.  Therefore, changes in the CPI
had relatively little effect on federal expenditures and had no
direct impact on federal receipts.  In the 1990s, however, the
federal government uses the CPI to index a much broader set of
programs, including federal income tax brackets and certain federal
payments, that directly affect a larger share of the population and a
much larger volume of federal receipts and expenditures.  These uses,
in our view, provide a commonsense basis for making the index a more
accurate reflection of what consumers are buying in a rapidly
changing economy. 

Updating the expenditure weights more often appears to be supported
from a cost-benefit standpoint as well.  BLS estimated that it would
cost $3.1 million over 3 years to update the expenditure weights in
2003.  If the growth in the CPI decreased by 0.1 percentage point per
year, CBO estimates show that this would lead to a cumulative total
of a $10.8 billion increase in the projected budget surplus over the
4 years after the update.\30 However, regardless of the effect on the
budget, the point of doing an update outside of a major revision
would be the increased value of having the CPI reflect, as closely as
practical, the current spending patterns of consumers. 


--------------------
\27 John S.  Greenlees, "Expenditure Weight Updates and Measured
Inflation" Bureau of Labor Statistics, February 27, 1997. 

\28 The Commissioner made these comments to the Subcommittee on
Economic Statistics of the Joint Economic Committee of Congress,
which was holding hearings on the recommendations of the Stigler
committee. 

\29 According to BLS, these are the base years that would have been
used if the CPI had been revised in 1992. 

\30 Under current budget rules, these could not offset each other. 
However, the estimates do give an indication of the overall impact on
spending and revenues. 


         FUNDING DIFFICULTIES
-------------------------------------------------------- Letter :7.2.2

Funding for past major revisions has not always been easy to obtain. 
The 1987 revision was delayed 1 year because of funding limits. 
Similarly, the scheduled 1998 revision's start was delayed 1 year,
until 1995, because of funding limits.  A former BLS Commissioner
with whom we spoke also identified funding as a problem.  She said
that funding for past major revisions was held up either within the
Department of Labor, by OMB, or in the appropriations process. 

Even before the tenure of this former Commissioner, obtaining funds
to revise the CPI was apparently a problem.  In 1961, the then BLS
Commissioner, in testifying before a congressional committee,
explained that under the then present practice, revisions to the CPI
were undertaken only when BLS was successful in convincing the Bureau
of the Budget--now OMB--and Congress that there was an urgent need to
bring the CPI up to date. 

BLS also has had difficulty in obtaining funds, apart from a major
revision for improvements to the CPI in the early 1990s.  BLS
officials told us that they had requested $450,000 for the CPI to
improve quality adjustment procedures in consumer electronics,
shelter, and apparel, but it did not receive these funds from
Congress.\31


--------------------
\31 This information was obtained in connection with a report we
issued in 1995.  See Economic Statistics:  Status Report on the
Initiative to Improve Economic Statistics (GAO/GGD-95-98, July 7,
1995). 


         DATA AVAILABILITY
-------------------------------------------------------- Letter :7.2.3

BLS officials said CEX data and decennial census data are essential
to establishing the CPI expenditure weights.  CEX data are obtained
from consumers and identify the items of goods and services that
consumers have been purchasing.  Among their uses in the CPI,
decennial census data are used in selecting the geographic locations
from which samples of consumers are surveyed for CEX purposes. 

The BLS Commissioner said, in 1961, that more frequent updates
required a continuing CEX, which did not exist at that time.\32 The
current Commissioner said that, until the institution of the
continuing CEX that allowed BLS to decrease the number of units
surveyed and to make the CEX an ongoing program, an update of the
weights every 5 years would have been costly because it would have
required a special CEX.  However, a continuing CEX program has been
established, and, from a practical perspective, the first possible
5-year update of the weights using CEX data would have been in 1992,
which is 5 years after the first CPI revision (1987) that used the
continuing CEX data. 

The need to have the CPI reflect geographic movement of the
population as measured by the decennial census was cited by BLS
officials as a reason to make a major revision every 10 years. 
However, BLS officials said that they do not have to wait for new
decennial census data before updating expenditure weights. 


--------------------
\32 Data for the CEX were collected only when funding was provided
for a CPI revision, and the Commissioner was correct in saying that a
continuing CEX was not available in 1961.  Since 1979, CEX data have
been collected continuously, whereby respondents in the interview
portion of the CEX are interviewed every 3 months over 5 calendar
quarters.  In each quarter, one-fifth of the respondents are deleted
and replaced by new respondents. 


      BLS IS DECIDING HOW OFTEN TO
      UPDATE THE EXPENDITURE
      WEIGHTS
---------------------------------------------------------- Letter :7.3

Updating the market basket expenditure weights is not the only way in
which BLS could make the CPI more representative of current consumer
spending.  The Boskin commission recommended another way, which was
through the concept of superlative index formulas.  Although BLS
plans to publish a superlative index, BLS does not see it as a
replacement for the fixed market basket CPI.  As long as BLS
publishes the fixed market basket CPI, updating the weights more
often than once a decade would remain important.  BLS has the
technical ability now to update the expenditure weights and, in
commenting on a draft of this report, the BLS Commissioner said BLS
was developing a new updating policy.  To develop this policy,
according to the Commissioner, BLS was studying what frequency will
yield the most accurate CPI and best support the CPI's many uses. 


         PLANNED PUBLICATION OF
         SUPERLATIVE INDEXES
-------------------------------------------------------- Letter :7.3.1

According to the BLS Commissioner, the use of superlative indexes,
such as those BLS is producing on an experimental basis, is the
appropriate way to address what the Stigler committee sought in its
recommendation for more frequent updating of weights.  That is, a
superlative index reflects changes in consumer spending in response
to changes in relative prices, and, under certain assumptions, a
superlative index is free of upper-level substitution bias.  In
commenting on a draft of this report, the BLS Commissioner said that
since superlative indexes can be published only with a
representational lag because of the lack of current-period
expenditure as well as price data, their use in the CPI is precluded. 
The CPI, she said, is produced monthly and revised only in unusual
circumstances. 

Although BLS plans to begin publication of a superlative formula
index in 2002, BLS officials stated that they also plan to continue
to publish the fixed market basket CPIs.\33 Therefore, those who use
the CPI for escalation purposes would have to choose among the
published CPIs, including the fixed market basket CPI. 

In addition, the federal government's use of the CPI is legislatively
tied to the fixed market basket concept in some instances.  For
example, the U.S.  tax code specifically identifies the use of the
CPI-U for automatic inflation adjustments of federal income tax
brackets and deductions for personal exemptions.\34

Therefore, unless otherwise changed by legislation or unless BLS
named its superlative index the CPI-U, the fixed market basket CPI
would be used in these programs. 

The Boskin commission recommended that BLS replace the fixed market
basket CPI with two new index formulas as follows:  (1) an index that
would be updated annually and revised historically to incorporate
measurement improvements and (2) a monthly index that would be based
on a "trailing" 2- or 3-year average of CEX data.  According to the
Chairman of the Boskin commission, the annual index would use a true
superlative index formula, whereas the monthly index would use a
modified superlative index formula.  He said the spirit behind the
commission's recommendation was for BLS to move as close as practical
to creating a CPI that would be reflective of the cost of living. 

Although BLS plans to publish a superlative index in 2002, it has not
decided how this index will be constructed.  The Commissioner said
that true superlative indexes cannot be produced in "real time," or
monthly, because they require current expenditure data, which are
impossible to collect and process on a monthly basis.  In July 1997,
another BLS official told us that the superlative index that BLS
plans to publish in 2002 may be (1) an annual number with a 2-year
lag that, for example, would reflect inflation for the year 2000 or
(2) a current measure that would be subject to revision as more
current expenditure data become available.  According to the BLS
official, this second measure would not be considered a true
superlative index until the more current expenditure information was
incorporated. 

Although BLS has not decided on the construction of a superlative
index, one approach or index formula it is considering is referred to
as a Fisher Ideal superlative index.  As explained in appendix IV,
two different index values are combined to produce a Fisher Ideal
superlative index.  One of the two index values is based on the
Laspeyres index formula, which is the formula used to produce the
official CPI.  In other words, values from the CPI's fixed market
basket would be inputs to the Fisher Ideal index.  The other index
value used in this superlative computation is based on a Paasche
formula, which, unlike the Laspeyres formula, incorporates current
expenditure weights.  In general terms, the Fisher Ideal superlative
index reaches the middle ground between the Laspeyres and Paasche
formulas. 


--------------------
\33 Publishing variations of a consumer price index would not be
unusual.  Originally, when BLS announced that it would begin
publishing the CPI-U, which represents all urban consumers, it
planned to discontinue the older CPI-W, which represents urban wage
and clerical workers.  Since users, such as labor unions, supported
publication of the CPI-W, BLS changed its plans to drop the CPI-W and
now publishes both indexes. 

\34 26 U.S.C.  1(f). 


         BLS HAS TECHNICAL ABILITY
         TO UPDATE AND PLANS TO
         CONSULT WITH ADVISORY
         GROUPS
-------------------------------------------------------- Letter :7.3.2

According to BLS officials, BLS has the technical ability to update
the expenditure weights more frequently.  However, as of June 1997,
BLS was undecided as to whether it would update the weights outside
of major revisions to the CPI.  The Deputy BLS Commissioner said BLS
was still considering the matter and, as a first step, needed to make
a decision within BLS about updating the expenditure weights at times
other than major revisions.  In August 1997, in commenting on a draft
of this report, the BLS Commissioner said BLS was developing a new
updating policy.  To develop this policy and before making a final
determination, BLS plans to study a number of practical questions and
the Commissioner said that BLS will seek the advice of its advisory
councils, all with the intent of determining the best frequency for
updating the CPI weights. 


   CONCLUSIONS
------------------------------------------------------------ Letter :8

As the principal source of information on consumer prices and
inflation in the United States, the CPI should reflect current
consumer expenditures as much as practical.  That clearly was the
view of the Stigler committee in 1961 and of the Boskin commission in
1996. 

One step that BLS could take to advance that concept is to update the
expenditure weights of the CPI more often than only during major
revisions to the CPI.  The current practice of updating weights only
as part of a revision means that it is 10 years or more between
updates of the expenditure weights; this appears too long to achieve
a reasonable representation of current consumer spending.  The BLS
Commissioner said that she intuitively believed that 10 years between
updates was too long.  The two former BLS managers and eight CPI
researchers with whom we spoke all believed that, conceptually, the
weights should be updated more often than every 10 years.  According
to a BLS official and published information, other G-7 countries
update expenditure weights more often than every 10 years. 

However, BLS has held for some time that, although 10 years between
updates may seem inappropriate, there is no strong empirical evidence
that suggests a connection between the age of the weights and the
measurement of inflation.  Our examination of BLS data, however,
showed that the age of expenditure weights affects the measure of
inflation.  Although the data are not perfect and do not isolate the
effects of using outdated expenditure weights, comparisons of price
indexes employing BLS data with old and new weights indicate that
price indexes computed with more current weights were always
different than indexes computed with older weights.  This result has
been the case going back to comparisons made for the first revision
in 1940.  In addition, comparisons generally tend to show lower rates
of inflation with indexes using newer weights. 

There are also reasons for making certain that the expenditure
weights are, as much as practical, reflective of current consumer
spending.  Since 1962, the CPI has been legislatively connected to
adjusting some benefit payments for inflation and more recently to
adjusting federal tax brackets.  As a result, any overstatement or
understatement of inflation by the CPI can have a major impact on the
federal budget.  For example, if, beginning in 2003, CPI growth were
annually reduced by 0.1 percentage point and all policies and the
economy remained unchanged, CBO estimates that the federal budget
surplus over the 4 years following 2003 would be cumulatively $10.8
billion higher. 

We recognize that gaining financial support for revising or improving
the CPI has been a problem at times.  We cannot predict the ease or
difficulty BLS might have in getting funds to update the weights more
often (e.g., $3.1 million over 3 years that BLS estimated it would
need for an update in 2003). 

We also recognize that adjusting the weights more often does not have
the highest priority among all commentators on the CPI.  For example,
the Boskin commission would rather see BLS replace the fixed market
basket CPI with various types of superlative indexes.  However, even
if BLS published a superlative index, which it plans to do, the
updating of the weights more often would remain significant because
BLS does not view superlative indexes as replacements for the fixed
market basket CPI.  It plans to continue to publish the long-standing
fixed market basket CPI.  In addition, since BLS is still trying to
address basic conceptual issues in designing the superlative-type
index that it plans to publish in 2002, the uncertainty surrounding
this planned index suggests to us that making the fixed market basket
index as current and accurate as possible should be done. 


   RECOMMENDATION
------------------------------------------------------------ Letter :9

We recommend that, as long as a fixed market basket CPI is published,
the Commissioner of BLS should update the expenditure weights of the
CPI's market basket of goods and services more frequently than every
10 years to make it more timely in its representation of consumer
expenditures. 


   AGENCY COMMENTS AND OUR
   EVALUATION
----------------------------------------------------------- Letter :10

We sent a draft of this report to the Secretary of Labor, the Chair
of CEA, the Director of OMB, and the Chairman of the Board of
Governors of the Federal Reserve System and requested comments from
them or their designees.  The Commissioner of BLS provided comments
for the Department of Labor, and said she supports more frequent
updates of the expenditure weights.  However, the Commissioner said
neither economic theory nor empirical evidence demonstrates the
superiority of any particular update interval.  She said that BLS
needs to consider carefully what frequency will yield the most
accurate CPI and best support the many uses of the index.  There are,
she said, a number of practical questions related to developing a new
updating policy that BLS must address.  BLS is currently studying
these questions but, she said, the ultimate decision rests largely on
commonsense judgment.  Finally, the Commissioner emphasized that BLS
will not evaluate potential changes to calculating the CPI on whether
they raise or lower the measured rate of price change.  Rather, BLS
will evaluate potential changes on whether they produce a more
accurate index.  We agree with the Commissioner's statement that
potential changes to the CPI should be predicated on whether they
produce a more accurate index.  The Commissioner was silent as to
whether the new policy would direct an expenditure weight update
between major revisions, which have been every 10 years or so. 
Although we cannot say exactly how often the expenditure weights
should be updated, the evidence we reviewed suggested that updating
only once every 10 years or so was insufficient.  The Commissioner's
August 8, 1997, letter is reprinted at appendix V.  BLS provided
technical comments on the draft report by separate communication, and
we incorporated them as appropriate. 

By a letter dated August 8, 1997 (see app.  VI), CEA's Director of
Macroeconomic Forecasting said more frequent updating would be a
small improvement and ought to be considered.  However, the Director
hoped that readers of this report do not confuse more frequent
updating with the adoption of a true cost-of-living index. 

In an August 12, 1997, letter (see app.  VII), OMB's Associate
Director for Economic Policy said that frequent updating of
expenditure weights is one important option.  However, OMB believed
that BLS should consider more frequent updating in context with other
potential improvements.  The Associate Director pointed out that
substitution bias would remain in a Laspeyres-type index even with
more frequent updating of expenditure weights.  The CPI is a
Laspeyres-type index. 

The Federal Reserve's designee, the Assistant Director and Chief of
the Economic Activity Section, Division of Research and Statistics,
said in a July 31, 1997, letter (see app.  VIII) that the draft
report addressed a very important public policy issue.  He said that
more frequent updating of the expenditure weights would be desirable
absent other actions to improve the CPI's accuracy.  However, other
changes to the CPI, such as those recommended by the Boskin
commission, may do more to improve the CPI's accuracy.  He said our
recommendation for more frequent updating seemed to be only a
"second-best" solution, which the Federal Reserve did not endorse. 
The "first-best" solution, he said, is for BLS to depart from the
fixed-weight structure of the CPI. 

The comments from CEA, OMB, and the Federal Reserve all convey a
similar message that the CPI should be a true or ideal cost-of-living
index, which has been discussed in terms of changing the CPI's
construction from a Laspeyres index formula to a superlative index
formula.  As we stated in the sections of this report on our
objectives and methodology, it was not our intent to evaluate a
change in the basic formula used to construct the CPI.  However, the
BLS Commissioner in her comments on the draft report said, in part,
the following: 

     "Economic theory provides an elegant rationale for the use of
     superlative index
     formulas .  .  .  to provide approximations to a cost-of-living
     index.  .  .  .  The unfortunate limitation of superlative
     formulas is that their calculation requires current-period
     expenditure as well as price data, so superlative indexes can be
     published only with a lag.  This precludes their use in the CPI
     .  .  .  ."

As we previously discussed in this report and as the Commissioner
mentioned in her comments, the administration has asked Congress for
funds to produce a BLS superlative index beginning in 2002.  BLS also
plans to continue to publish the Laspeyres fixed market basket CPI. 
While we agree with those who commented that updating the expenditure
weights is not a fix for turning the CPI into a true cost-of-living
index, we believe that such updating makes sense for the fixed market
basket CPI as long as BLS continues to publish it. 

The Federal Reserve and CEA designees also expressed concern as to
whether we overstated the effect of more frequent updating on the
CPI.  Both cited one estimate (0.04 percentage point reduction) from
a February 1997 research paper written by a BLS official to support
their concern.\35 We believe we have not overstated the potential
effect.  We report that a 5-year update of the expenditure weights
could reduce the CPI's rate of growth by between 0 (zero) and 0.2
percentage point per year.  This range was estimated by BLS on the
basis of historical evidence, which was provided in this February
1997 research paper.  BLS has raised no second thoughts to us about
the reasonableness of this range.  For example, BLS did not question
the range in commenting on our draft report.  As we report in
appendix III, the BLS research paper provided a number of different
point estimates that are based on regression analyses, overlap
comparisons, and other studies.  The regression analysis from which
the 0.04 percentage point estimate was derived found evidence of a
small effect--rather than no effect--on measured inflation.  In
addition, the 0.04 percentage point estimate was within the lower end
of the range of estimates that BLS provided to us. 

CEA, OMB, and the Federal Reserve each made additional comments,
which are addressed as appropriate in appendixes VI, VII, and VIII. 


--------------------
\35 Greenlees, op.  cit. 


--------------------------------------------------------- Letter :10.1

As arranged with your office, unless you publicly announce its
contents earlier, we plan no further distribution of this report
until 30 days after its issue date.  At that time, we will send
copies of this report to the Chairman of this Committee; the Chairmen
and Ranking Minority Members of other interested congressional
committees; the Secretary of Labor and the Commissioner of BLS; the
Director and the Chief Statistician of OMB; the Chair of the Council
of Economic Advisers; and the Chairman of the Board of Governors of
the Federal Reserve System.  We will also make copies available to
others on request. 

Major contributors to this report are listed in appendix IX.  If you
have any questions about this report, please call either of us. 
Bernard Ungar can be reached on (202) 512-8676, and James Bothwell
can be reached on (202) 512-6209. 

Sincerely yours,

Bernard L.  Ungar
Associate Director
Federal Management and
 Workforce Issues


James L.  Bothwell
Chief Economist


OBJECTIVES, SCOPE, AND METHODOLOGY
=========================================================== Appendix I

To obtain views on updating the Consumer Price Index's (CPI)
expenditure weights more often than every 10 years, which addressed
our first objective, we asked two former Bureau of Labor Statistics
(BLS) officials and eight individuals who have studied the CPI for
their views on how often the CPI should be updated.  Of these eight
individuals, one was a member of the Stigler committee; four were
members of the Boskin commission; one had developed a superlative
index theory that BLS was considering in connection with the CPI; and
two had studied the Boskin commission's report.  These latter three
researchers were recommended to us by the Boskin commission members
we interviewed or others because their views were neutral or differed
from the Boskin commission's position on the amount of bias in the
CPI.  We also reviewed public statements made by the Chairman of the
Board of Governors of the Federal Reserve System concerning the
frequency of updating the CPI.  To obtain information on the
practices followed by other industrialized countries in updating
their consumer price indexes, which also addresses our first
objective, we obtained information from BLS and from publications of
the Organization for Economic Cooperation and Development and the
Canadian government on how often the G-7 countries update their CPIs. 

To estimate the cost to BLS of updating the CPI on a 5-year cycle,
our second objective, we asked BLS to provide us with certain actual
and estimated cost data.  We asked BLS to provide us with the costs
associated with the last major revision of the CPI, which took place
in 1987, and the projected costs for the 1998 revision.  In addition,
we asked BLS for its estimate of what the costs would have been to
update the CPI in 1992 and its estimate of what the cost might be to
update the CPI in 2003.  In other words, we asked BLS to provide cost
data for a prior revision (1987), a planned revision (1998), and two
updates (1992 and 2003).  The interval between 1992 and 1998 is 6
years rather than 5 years, but that difference was unavoidable given
that a major revision is scheduled for 1998.  We did not specify to
BLS what assumptions to make or what items to include or exclude in
estimating costs for 1992, 1998, and 2003.  We did not evaluate the
reasonableness of BLS' assumptions or estimates. 

BLS provided cost data for the 1987 revision, the upcoming 1998
revision, and a 2003 update.  BLS suggested that the cost for a 1992
update could be derived by deflating the cost of the 2003 update. 
For this conversion, we compared the Object Class 11 index published
by the Office of Management and Budget (OMB), which is used to adjust
pay categories, and the Gross Domestic Product (GDP) price index as
determined by the Department of Commerce's Bureau of Economic
Analysis, which is used to adjust all other budget categories.  We
found minor differences between using the two deflators and chose to
use the GDP price index, which, in comparison to the Object Class 11
deflator, led to a slight overstatement of the cost and, in reference
to our cost-benefit comparison, provided a conservative estimate. 

To address our third objective--estimate the dollar effect on the
federal budget if the CPI weights were updated on a 5-year cycle--we
obtained assistance from BLS and the Congressional Budget Office
(CBO).  We asked BLS to estimate whether the CPI would go up or down
as the result of a 5-year update.  More specifically, we asked BLS to
provide a range--an upper percentage point and a lower percentage
point--of the possible change that could occur to the CPI with a
5-year update. 

To gauge the reasonableness of estimates that BLS provided, we
compared them with the results of BLS' overlap studies of old and new
weights during the first 6 months of major revisions and other BLS
studies that examined the impact of more frequent updates.\1

The results of these comparisons are reported in appendix III. 

We then asked CBO to estimate the effects that a 5-year update of the
CPI in 2003 would have on federal outlays, revenues, debt service,
and the overall budget, assuming no other changes in tax or spending
levels and no other changes in the economy.  To do this, we asked CBO
to use BLS' lower and upper estimates and the midpoint of these
estimates of change in the CPI that would result from a 5-year
update.  To illustrate the effect of a 5-year update that would begin
in 2003, we asked CBO first to apply its standard projections for the
years 2004 through 2007;\2 the results represented CBO's baseline. 
CBO then made additional projections for the years 2004 to 2007 to
account for changes in the CPI as estimated by BLS for a 5-year
update, and we compared these projections against CBO's baseline.  To
adjust the CPI for the effects of a 5-year update of the expenditure
weights, CBO reduced its estimated CPI by 0.2 percentage point, which
BLS had estimated could be the upper estimate of change in the CPI
from a 5-year update.  The difference between the baseline and the
adjusted CPI estimates was reported by us as the upper estimate of
the dollar effect of a 5-year update on the federal budget.  Similar
estimates and calculations were made with the midpoint--0.1
percentage point--of BLS' estimate.  No further estimates and
calculations from the baseline were necessary to account for BLS'
lower estimate of change, which was 0 (zero). 

We also reported these estimates in footnote 23 of this report in
1997 constant dollars by applying the GDP price index.  We calculated
the 1997 constant-dollar amounts using the GDP price index.  Dollar
amounts for years other than the base year (1997) were adjusted for
the effect of inflation with the GDP price index.  These adjustments
had the effect of increasing the amounts for the years before 1997
and of decreasing the amounts for the years after 1997. 

CBO would provide projections for current and future years but not
provide estimates for past years.  Therefore, after discussion with
CBO, we estimated how the federal budget deficit might have been
affected if the expenditure weights were updated in 1992.  In making
our estimates, we assumed that there were no other changes in tax or
spending levels and no other changes in the economy for 1992 through
2007.  We also assumed that the economic trend that was found for the
years 1998 through 2007 could be reasonably applied to the years 1993
through 1998. 

We first replicated CBO's estimates for outlays and revenues that are
affected by the CPI for 1998 through 2007 from projections for the
relevant categories published in CBO's Economic and Budget Outlook in
January 1997.\3 We then asked CBO to follow the previously described
methodology and to make estimates of a 0.1 percentage point reduction
in the CPI beginning in 1997 and 2002.  We also replicated CBO's
estimates of a 1.0 percentage point change in the CPI on the federal
deficit that was published in January 1997 and adjusted the estimates
to represent a 0.1 percentage point reduction.\4 We then compared the
effects of these two estimates on revenues and outlays and found
significant differences in the revenue estimates that were due to
rounding rules for tax revenues.  We chose to use CBO's published 1.0
percentage point estimates that were adjusted to represent a 0.1
percentage point reduction rather than those that were calculated for
us by CBO because the published 1.0 percentage point estimates that
were adjusted to represent a 0.1 reduction provided a more
conservative estimate, as well as a smooth trend.  The effects from
the adjusted 1.0 percentage point reduction were then applied to the
outlay and revenue totals that are affected by changes in the CPI in
each year from 1993 to 1998.\5

Debt service costs were calculated from the year-to-year change in
CBO's baseline debt, less the saving from changes in outlays and
revenues.  The current-dollar estimates derived from these
calculations were adjusted with the GDP price index to 1997 constant
dollars.  The estimates for the 0.1 percentage point reduction were
doubled to obtain estimates for a 0.2 percentage point reduction in
the CPI.  We met with CBO to discuss our approach, and CBO staff
stated that the method and results appeared reasonable. 

In connection with the effect on the federal budget, we asked the
Chief Actuary of the Social Security Administration (SSA) to estimate
the effect a change in the CPI would have on the average benefit paid
to retired workers.  Your office had requested that we obtain this
information to illustrate how a federal revenue or payment program
that is adjusted periodically because of changes in the CPI might be
indirectly affected by more frequent updating of the expenditure
weights.  To make the estimate, we asked SSA to use the midpoint of
BLS' range of possible change that would occur to the CPI with a
5-year update.  Using that midpoint percentage point and the
President's Fiscal Year 1998 Budget assumptions, SSA estimated the
change in the average monthly benefit, beginning with December 2003,
which would be payable in January 2004, and continued through
December 2007. 

Our fourth objective had the following two elements:  (1) identify
the reasons for the 10 years or so between revisions and (2) assess
those reasons.  For the first element, we interviewed present and
past officials of BLS and obtained their views on why major updates
to the CPI have been spaced about 10 years apart.  Among the
officials we interviewed were the present Commissioner of BLS and a
former Commissioner of BLS.  We also reviewed the 1961 congressional
testimony of another BLS Commissioner in which he addressed the
subject of BLS' timetable for revising the CPI.  In our assessment of
BLS' reasons, we (1) collected and analyzed information on past
comparisons between indexes that applied old and new expenditure
weights, which were also used to address the reasonableness of BLS'
estimates under our third objective; (2) obtained information on how
BLS collects its source data for the CPI; (3) obtained BLS fiscal
year 1998 budget information to ascertain BLS' plans for future
changes in its indexes; and (4) compared the estimated costs and
benefits of a 5-year CPI update cycle obtained under our second and
third objectives. 

In our assessment of past comparisons between indexes that applied
old and new weights, we noted that the indexes reflect differences in
addition to those directly related to changes in expenditure weights,
such as conceptual changes in the structure of the market basket. 
These differences are a result of data limitations in that the
overlap periods incorporate many factors that can be changed in a
revision.  With this knowledge, we treated the differences as
indicators of the effect of an update of the expenditure weights
because an update of the weights is unlikely to occur in isolation
from the other factors that are associated with revisions.  For
example, a 1992 update would have incorporated a market basket that
would have been based on different geographic areas because changes
were made in 1986 in the geographic locations where expenditure data
were collected.  Such geographic changes are associated with major
revisions. 

In addition to reviewing overlap studies, we examined the effect of
the age of weights with indexes that were calculated with alternative
base periods.  For example, comparisons were made of the official
CPI's 3-year base of 1982 through 1984 with alternative 3-year base
periods (i.e., 1987 through 1989).  In these and other comparisons,
we applied an economic concept that is based upon economic literature
that suggests that an index is more accurate if the expenditure
weights used to compute it represent, as much as practical, current
consumer spending. 

As previously reported, this report includes, and often relies on,
estimates and comparisons prepared by BLS, CBO, or SSA.\6 We did not
verify the computerized data that the agencies used in producing
these estimates and comparisons.  Verification, in our opinion, would
have been impractical because it would have been costly and time
consuming.  In addition, the estimates and comparisons were within
the scope of activities that BLS, CBO, and SSA normally perform. 
Therefore, we used their estimates and comparisons. 

Our work was designed to examine the importance of updating the CPI
sooner than about once every 10 years.  The results we obtained are
intended to contribute to the discussion of how often the CPI should
be updated but are not intended to represent all future effects of
shortening the updating cycle.  The point of shortening the updating
cycle is to have the CPI reflect, as close as practical, the current
spending patterns of consumers, regardless of whether the index is
pushed upward or downward.  Our work is also not intended to evaluate
a change in the basic formula that could address substitution bias in
the CPI. 


--------------------
\1 Mary Lynn Schmidt, "Comparison of the Revised and the Old CPI,"
Monthly Labor Review, Vol.  110 (Nov.  1987), pp.  3-6.  Mary Lynn
Schmidt, "Effects of Updating the CPI Market Basket," Monthly Labor
Review, Vol.  116 (Dec.  1993), pp.  59-62.  Government Price
Statistics:  Hearings Before the Subcommittee on Economic Statistics
of the Joint Economic Committee of the Congress of the United States. 
79th Cong., 1st Sess., pp.  582-585, (1961), (statement by Ewan
Clague, Commissioner of Labor Statistics).  John S.  Greenlees,
"Expenditure Weight Updates and Measured Inflation," Bureau of Labor
Statistics, February 27, 1997. 

\2 Because CBO's projections do not go beyond 10 years, CBO did not
make a projection for 2008, which would be the fifth year of our
illustrative 5-year span.  The first year of CBO's projections was
1998. 

\3 See The Economic and Budget Outlook:  Fiscal Years 1998-2007, CBO
(Washington, D.C.:  1997), pp.  24 and 36.  The relevant category for
revenues is individual income taxes.  Spending programs affected by
changes in the CPI include Supplemental Security Income, veterans'
compensation and pensions, Social Security, and federal civilian and
military retirement. 

\4 See The Economic and Budget Outlook:  Fiscal Years 1998-2007, p. 
41. 

\5 Actual amounts were used for 1992 through 1995; CBO estimates were
used for 1997 and 1998. 

\6 BLS estimated (1) the cost to update the expenditure weights and
(2) the range of percentage effect on the CPI if the expenditure
weights were updated at 5-year intervals.  BLS also provided us with
its past comparisons of old-weighted and new-weighted indexes.  CBO
estimated the dollar effect on the federal budget if CPI growth were
lowered 0.1 percentage point or 0.2 percentage point annually.  SSA
estimated the impact on Social Security payments if the CPI were
reduced annually by 0.1 percentage point. 


BACKGROUND INFORMATION ON THE
CONSUMER PRICE INDEX
========================================================== Appendix II

BLS produces the CPI by measuring the average change over time in the
prices paid by urban consumers for a fixed market basket of consumer
goods and services.  The market basket is determined from detailed
records of purchases made by thousands of individuals and families. 
The items selected for the market basket, such as potatoes, are to be
priced each month at retail outlets, such as grocery stores, in urban
areas throughout the country.  According to BLS, in 1995, field
representatives visited approximately 30,000 retail establishments
and housing units each month, with prices collected for 94,000 items. 

The CPI is used as a measure of price changes to make economic
decisions in the private and public sectors.  According to BLS, the
CPI has three major uses as follows: 

  -- Economic indicator of inflation.  The administration, Congress,
     and the Federal Reserve use trends in the CPI as an aid to
     formulating fiscal and monetary policies.  Business and labor
     leaders, as well as private citizens, use the CPI as a guide to
     making economic decisions. 

  -- Escalator for wages, benefit payments, and tax brackets.  In
     1996, the CPI was used by collective bargaining units to adjust
     the wages of 1.7 million workers.  It is used to adjust some
     federal benefit payments for inflation.  For example, in
     September 1996, as a result of changes in the CPI, 43.5 million
     Social Security beneficiaries; 6.6 million Supplemental Security
     Income recipients; 6.4 million railroad, military, and federal
     civilian retirees and survivors; and 25.8 million food stamp
     recipients had their benefits adjusted for inflation.  The CPI
     is also used to adjust the federal individual income tax
     structure to prevent bracket creep (i.e., increases in real tax
     rates due solely to inflation).  Some benefit payments, such as
     those for Social Security recipients; tax deductions for
     personal exemptions; and tax brackets are adjusted automatically
     by the CPI, rather than on the basis of discretionary policy
     decisions. 

  -- Deflator of selected economic statistical data series.  The CPI
     is used to adjust selected economic statistical series for price
     changes and to translate these series into inflation-free
     dollars.  Examples of data series that are adjusted by the CPI
     include retail sales, hourly and weekly earnings, and components
     of the National Income and Product Accounts. 

The CPI was initiated during World War I, when rapid increases in the
prices of goods and services, particularly in shipbuilding centers,
made such an index essential for calculating cost-of-living
adjustments in wages.  In 1921, BLS began regular publication of an
index representing the expenditures of urban wage and clerical
workers, which was then called the Cost-of-Living Index.  The name of
the index was changed to the CPI following controversy during World
War II over the index's validity as a measure of the cost of living. 
According to BLS, the CPI has always been a measure of the changes in
prices for goods and services purchased for family living. 

Major revisions were made to the CPI about every 10 years to update
the fixed market basket; the next major revision is scheduled to be
released in January 1998.  Because consumers' buying habits changed,
new studies were made of what goods and services consumers were
purchasing, and major revisions to the CPI were made in 1940, 1953,
1964, 1978, and 1987.  In the 1978 major revision, several changes
were made, including the publication of a new index for all urban
consumers--the CPI-U.  According to BLS, the CPI-U, which represents
the expenditures of about 80 percent of the population, takes into
account the buying patterns of professional employees, part-time
workers, the self-employed, the unemployed, and retired people, as
well as those previously covered in the CPI.  BLS has continued
publication of the older index, the CPI-W, which represents the
expenditures of urban wage and clerical workers, or about 32 percent
of the population. 


   CONSTRUCTION OF THE CPI
-------------------------------------------------------- Appendix II:1

Construction of the CPI begins by selecting a collection of goods and
services that is usually bought by the reference population in the
index.  The collection of goods and services, called items, is known
as the market basket.  The CPI market basket is developed from
detailed expenditure information that is provided by families and
individuals who participate in the Consumer Expenditure Survey (CEX). 
Altogether, about 29,000 individuals and families provide expenditure
information for use in determining the importance, or weight, of each
item in the index structure.  These data are also used to select the
categories of items from which specific, unique commodity and service
items are selected to be priced for the CPI. 

BLS measures price changes each month by checking the prices of the
items in the market basket and then comparing the aggregate costs of
the market basket with those for the previous month.  BLS field
representatives obtain prices for most of the items through personal
visits to approximately 30,000 retail establishments and housing
units. 


      COMPONENTS
------------------------------------------------------ Appendix II:1.1

BLS classified all CEX expenditure items into 206 item strata, which
are arranged into 7 major components:  (1) food and beverages; (2)
housing; (3) apparel and upkeep; (4) transportation; (5) medical
care; (6) entertainment; and (7) other goods and services, such as
haircuts, college tuition, and bank fees.  Taxes that are directly
associated with the prices of specific goods and services, such as
sales and excise taxes, are also included.\1


--------------------
\1 The CPI excludes taxes not directly associated with the purchase
of consumer goods and services, such as income and Social Security
taxes.  The CPI does not include investment items, such as stocks,
bonds, real estate, and life insurance, because they relate to
savings, not daily living expenses. 


      EXPENDITURE WEIGHTS
------------------------------------------------------ Appendix II:1.2

Expenditure weights are used to give proportionate emphasis for price
changes of one item in relation to other items in the CPI. 
Expenditure weights allow the CPI to distinguish between items that
have a major impact on consumers and to provide appropriate emphases
to price changes associated with these items. 

The weight of an item in the CPI market basket is derived from
consumers' expenditures as reported in the CEX.  To compute the
weight, BLS first totals the amount spent on an item stratum, such as
white bread, by CEX respondents during the base weighting period. 
BLS then divides that total by the number of CEX responding units,
which results in an average expenditure per unit.  Next, the average
expenditures per unit are weighted with data from the decennial
census to represent the U.S.  urban population.  To do so, the
average expenditure amounts are multiplied by certain factors to
represent the geographic dispersion of the urban population. 
Finally, these nationwide urban expenditures on the market basket
items are totaled into an aggregate amount.  The 206 expenditure
weights are the percentages of this aggregate amount that are spent
on each of the 206 item strata (e.g., white bread). 

On the basis of average expenditures during the reference period,
expenditure weights remain fixed, or constant, until the next major
revision of the CPI and serve as a benchmark from which price
comparisons are calculated.  The weights of the components for the
last major revision in 1987 are those as derived from the 1982
through 1984 CEX (see fig.  II.1). 

   Figure II.1:  Expenditure
   Weights Used for the 1987 CPI
   Revision

   (See figure in printed
   edition.)

Note:  Percentages do not total to 100 percent because of rounding. 

Source:  BLS. 


      PRICING OF MARKET BASKET
      ITEMS
------------------------------------------------------ Appendix II:1.3

Each month, BLS field representatives visit or call thousands of
retail stores, service establishments, rental units, and doctors'
offices all over the United States.  For the entire month, they
record the prices of about 94,000 items.  To determine which retail
outlets its representatives should visit to obtain its monthly price
quotations, BLS sponsors the Point-of-Purchase Survey (POPS), which
is conducted by the Bureau of the Census.\2

The survey respondents are asked, by item categories such as doctors,
whether they made specific purchases and, if so, the names and
locations of all places of purchases and the expenditure amounts. 
BLS uses the results from the survey to select outlets for pricing. 
This survey is conducted in approximately 20 percent of a sample of
urban areas each year; as a result, the entire nonshelter sample is
updated every 5 years. 

BLS field representatives visit each selected outlet to initially
select items that will be priced either monthly or bimonthly.  For
each outlet, categories of items are selected for pricing.  Using
probability selection methods that are based on revenues and volume
information that is provided by the retail outlet, BLS field
representatives use a table of random numbers to select for pricing a
unique item within the specified categories.  The monthly price
changes for the same item (e.g., cigarettes) that are collected by
BLS field representatives in urban areas throughout the United States
are averaged, weighted, and published.  Because the concepts BLS uses
to measure medical care and shelter costs are different than those
used for the items previously described, the pricing of these items
is approached in a different manner. 


--------------------
\2 The POPS also is used to establish the point-of-purchase weights,
which are used to combine the prices of the 94,000 items into the 206
item strata. 


ANALYSIS OF PRICE INDEXES WITH
ALTERNATIVE EXPENDITURE WEIGHTS
========================================================= Appendix III

BLS reported that historical evidence suggests that a 5-year update
of the market basket could reduce the rate of growth of the CPI by
between 0 (zero) and 0.2 percentage point per year.  Regarding the
effect of a 1991 update to the CPI, BLS cited one specific source of
evidence that shows the rate of growth would be lower by 0.11
percentage point.  In addition, BLS states that the effect of
updating the expenditure weights in 1998 will likely be a reduction
of 0.1 or 0.2 percentage point.  As a result of this and other
information, we chose 0.1 percentage point, the midpoint of BLS'
range, for the purposes of our calculations. 

Evidence on the possible impact of more frequent updates of
expenditure weights on the rate of growth of the CPI includes overlap
studies performed by BLS at the time of major revisions and other CPI
index comparisons using specialized databases.  BLS has been
performing overlap studies for more than 50 years, and these studies
consistently have shown a difference between indexes computed with
old and new weights.  In most of these cases, indexes computed with
the old weights show a higher rate of growth than indexes computed
with the new expenditure weights.  Other evidence includes
alternative CPI index series, which were computed using databases
that allow comparisons between old and new weights.  Indexes computed
with new expenditure weights almost always produce different results
than indexes with old weights.  These same data also suggest that
indexes relying on older expenditure weights typically show a higher
rate of growth than indexes computed with newer expenditure weights. 
An upward bias in indexes computed with older expenditure weights is
consistent with economic theory and other evidence.  In our analysis,
we applied an economic concept that an index was more accurate if the
expenditure weights used to compute it represented, as much as
practical, current consumer spending. 


   BLS OVERLAP STUDIES
   CONSISTENTLY SHOW DIFFERENCES
   BETWEEN INDEXES CALCULATED WITH
   OLD AND NEW WEIGHTS
------------------------------------------------------- Appendix III:1

BLS began performing overlap studies for its work on the first
revision of the CPI in 1940.  In these overlap studies, BLS computed
two indexes for the same period.  One index was calculated with the
original weights, and one was computed with more recent weights.  As
a result, these overlap indexes provide evidence on the effects of
updating weights over a long period and under different economic
conditions. 

In those cases where there were no important changes in other
procedures or other anomalies, the difference between these two
indexes can be attributed to the change in weights.  However, BLS has
often instituted new procedures and improvements as a part of the
revisions, along with the updates to the expenditure weights.  These
improvements could include changes in geographic coverage, adoption
of probability sampling methods, and other changes.  Those changes
and any unusual economic conditions at the time of the revision limit
the applicability of the overlap findings to current questions
regarding the likely effects of updating expenditure weights. 

In all of the overlap comparisons, differences were found between
indexes calculated with the new weights and indexes calculated with
the old weights.  In five of the seven comparisons, the indexes with
the new weights recorded a lower rate of inflation than those with
the old weights.  In the two instances where the new weights resulted
in higher rates of growth, changes in price collection methodology
and the aftermath of the wartime economy might have had an effect on
those results. 


      STUDIES FOR THE 1940
      REVISION
----------------------------------------------------- Appendix III:1.1

As a part of the first revision of the CPI in 1940, BLS conducted
three comparisons that used expenditure weights that were derived
from 1917 through 1919 Consumer Expenditure Survey (CEX) data (old
weights) and weights from 1934 through 1936 CEX data (new weights). 
Comparisons were conducted for three different periods using the old
and the new weights:  1925 through 1929, June 1930 through March
1935, and March 1935 through December 1939.  Differences were
reported for all three comparisons, and, in each case, the CPI with
the old weights had a higher rate of growth than the index computed
with new weights.  In the periods beginning 1925 and 1935, the
difference between the two indexes was small, but the difference
between the overlapping indexes for the period beginning in 1930 was
more than 1 percent (see table III.1). 



                              Table III.1
                
                 Results From 1940 CPI Revision Overlap
                                 Tests

                          (Numbers in percent)

                                 Rate of        Rate of
                             growth with    growth with
Calculation period           new weights    old weights     Difference
-------------------------  -------------  -------------  -------------
1925 -1929\a                        -3.7           -3.6           -0.1
June 1930 -March 1935\a            -18.7          -17.5           -1.2
March 1935 -December 1939            1.8            1.9           -0.1
----------------------------------------------------------------------
\a During periods of deflation, the indexes computed with the old
weights showed less deflation than indexes computed with the new
weights. 

Source:  BLS. 


      OVERLAP STUDIES FOR 1953
      THROUGH 1987 REVISIONS
----------------------------------------------------- Appendix III:1.2

In response to a presidential request, BLS also conducted an overlap
study related to the 1953 revision.  In this case, BLS applied the
weights used in the 1940 CPI revision to January 1953 through June
1953 price data, the first months following the implementation of the
1953 revision.  A comparison of the indexes computed with these two
sets of weights showed that, unlike the previous 1940 revision
studies where the old weights produced a higher rate of growth than
the new weights, the index with the old weights showed growth of 0.5
percentage point less than the index using the new weights (see table
III.2).\1 These results may be an anomaly related to the use of the
1947 through 1949 CEX data as the base period for the 1953 revision. 
Consumption in those years reflected the purchases of consumers
following World War II, and the change may reflect unusual changes in
consumer preferences or changes in the availability of various goods
and services. 



                              Table III.2
                
                Estimates of Difference in Annual Rates
                 of Growth Between Old and New Weights,
                           by Major Revision

                          (Numbers in percent)

Revision year                                               Difference
----------------------------------------  ----------------------------
1953\a                                                            -0.5
1964                                                               0.4
1978                                                              -0.2
1987                                                               0.8
1998\b                                                        0.1/0.2\
----------------------------------------------------------------------
Note:  A negative number indicates that the price index using old
weights was lower than the index using new weights. 

\a The months of comparison were January through June 1953. 

\b BLS forecast. 

Source:  BLS. 

In the more recent series of overlap studies, BLS calculated the CPI
with both the old and new weights for 6 months following a major
revision.\2 In the 1964 and the 1987 revisions, indexes computed with
the old weights produced higher growth rates than indexes computed
with the new weights.  Overlap indexes computed for the 1978 revision
showed the reverse (see table III.2).  BLS suggested, however, that
the lower rates of inflation produced by the older weights may have
been due to a 1978 change in methods used to select items for monthly
pricing (see app.  II).  According to BLS, an upward bias could have
been reflected in the index calculated with the new weights, and
could have caused the higher rates of inflation using the new
weights.  In addition, BLS estimated that, for the upcoming 1998
revision, measured inflation will likely be reduced by 0.1 or 0.2
percentage point. 


--------------------
\1 The 1940 revision expenditure weights are considered the old
weights in this section; whereas the 1953 revision weights are
considered the new weights.  In each of the following discussions,
the old weights are those that were used through December before the
introduction of the revision under discussion; the new weights are
those that were introduced in January of the revision year under
discussion. 

\2 The results from these studies are reported in a research paper
written by a BLS official (Greenlees, op.  cit.). 


   ALTERNATIVE CPI SERIES COMPUTED
   WITH OLD AND NEW WEIGHTS ALSO
   SHOW DIFFERENCES
------------------------------------------------------- Appendix III:2

Additional evidence on the effect of more frequent updates of
expenditure weights is available from comparisons of index series
computed with old and new weights.  These calculations are performed
on databases that have been constructed to allow comparisons of
various index weights and methodologies.  Although these databases
are not available for the historical periods covered by the overlap
indexes, they make it possible to compare a number of alternative CPI
series that are based on various combinations of 1- and 3-year
weights for 1982 through 1995.  For example, one database has been
used to compare the actual CPI, which is based on 1982 through 1984
weights, with indexes that were computed with 3-year weights from the
following periods:  1987 through 1989, 1988 through 1990, 1989
through 1991, and 1990 through 1992.  Other databases have been used
to compare CPI rates of growth that are based on various combinations
of 1-year weights. 

Evidence from these databases suggests that changing the weights used
in the computation of the CPI will usually change the rate of growth
of the CPI.  These rate of growth differences vary according to the
database, the years used for the older and newer weights, and the
specific time frame and methodology used for computing the index.  As
in the case of the overlap studies, most of the evidence suggests
that older weights typically produce a higher rate of growth in the
CPI than indexes computed with newer weights.  For example, a
comparison of indexes computed with the 1982 through 1984 base period
and the indexes computed with weights that were based on the 1987
through 1989 periods indicated that the older weights overstated
inflation by approximately 0.1 percentage point per year over a
5-year period.  BLS cited this and other evidence to support its
statement that a 5-year update would reduce the measured rate of
inflation by between 0 and 0.2 percentage point per year.\3

As in the case of the overlap studies, BLS noted that the difference
between the two indexes cannot be attributed only to changes in the
weights.  In those instances when there are important changes in
procedures or anomalies in the data, the differences may not be an
accurate reflection of the changes in the weights.  BLS also noted
that the differences may be affected by the overall rates of
inflation, in that differences may be larger during periods when the
overall inflation rates are higher. 


--------------------
\3 Greenlees, op.  cit. 


      ALTERNATIVE INDEXES WITH
      3-YEAR BASE PERIODS
----------------------------------------------------- Appendix III:2.1

BLS research that compared the 1982 through 1984 expenditure- based
CPI (official) with alternative 3-year expenditure base periods
indicated that the official CPI rose slightly faster, on average,
than the alternative indexes with more current weights.  For example,
comparisons of the actual CPI with indexes computed with 3-year base
periods starting with 1987 through 1989 and ending with 1990 through
1992 showed that the increases in the official CPI were often higher
than the alternative indexes with more recent base periods, but there
was no consistent finding across all of the 3-year combinations.  In
fact, price changes for 1994 for two of the more recent base-period
indexes (1987 through 1989 and 1989 through 1991) were larger than
the official CPI for that year. 


      ALTERNATIVE INDEXES WITH
      1-YEAR BASE PERIODS
----------------------------------------------------- Appendix III:2.2

Two separate databases were also created that allowed additional
comparisons to be made between the CPI rates of growth, using a
number of alternative index calculation methods and 1-year base
periods.  The following different expenditure base periods were
available in those databases:  (1) 1986 through 1995 and (2) 1982
through 1995.  These two databases allow a variety of comparisons to
be made of indexes, using different base-period expenditure weights. 

BLS used a regression analysis to summarize the effect that the age
of the weights has on price indexes.\4 The analysis that was based on
the first database provided no evidence that a price index calculated
with more current weights will produce a lower rate of inflation than
an index calculated with older weights.  However, BLS' regression
analysis with the second database found evidence that more current
base weights yield smaller estimates of price change.\5 In other
words, indexes based on older expenditure weights tended to show a
higher rate of inflation than indexes with more recent weights. 

These data were also used to more directly address the question of
the impact of a 5-year update on the rate of measured inflation.  For
this purpose, BLS compared inflation estimates obtained with the 1982
through 1984 weights with the inflation rates that would have been
produced by 1987 through 1989 weights (see table III.3).  This
comparison indicated that, on average, inflation was lower by 0.11
percentage point with the 1987 through 1989 average than with the
1982 through 1984 average (i.e., a 5-year update would have reduced
inflation by an average of about 0.11 percentage point per year). 
BLS noted, however, that the difference varied widely from year to
year. 



                              Table III.3
                
                Estimates of Difference in Annual Rates
                  of Growth Between 1982 Through 1984
                 Weights and 1987 Through 1989 Weights

                          (Numbers in percent)

                            Average rate   Average rate
                               of growth      of growth
                            with 1982-84   with 1987-89
Revision year                    weights        weights     Difference
-------------------------  -------------  -------------  -------------
1991                                4.23           4.04           0.20
1992                                3.02           2.95           0.07
1993                                2.94           2.82           0.13
1994                                2.64           2.59           0.05
1995                                2.84           2.73           0.11
Average                             3.13           3.02           0.11
----------------------------------------------------------------------
Source:  BLS. 


--------------------
\4 In many of these regressions, BLS also estimated the difference
between a chained Fisher index and a 1-year Laspeyres index estimate. 

\5 BLS suggested that the incorporation of the 1980 census-based
geographic samples into the CEX in 1986 could explain the difference
between their two regression analyses.  BLS also looked at spending
distributions during the period before the change in samples and
found that no particular market basket item (such as energy or
high-tech consumer goods) contributed to the differences. 


PRICE INDEX FORMULAS
========================================================== Appendix IV

A consumer price index may be computed with one of several index
formulas.  The purpose of this appendix is to illustrate several of
those formulas. 

BLS constructs the CPI with a modified Laspeyres index formula.\1
According to the economist George Stigler, a Laspeyres index formula
produces an "upper" bound of the cost of living; whereas, the Paasche
index formula produces a "lower" bound of the cost of living.\2 A
superlative index, such as the Fisher Ideal index formula, is
regarded by economists as providing a good approximation to a
cost-of-living index. 

To illustrate the three basic index formulas, we use information from
hypothetical weekly grocery bills of a single woman who eats
breakfasts and five dinners at home; the rest of her meals are eaten
away from home (see table IV.1).  In the first and second weeks, she
purchased the same identical items, with price increases occurring in
the second week for some items.  In the third week, the prices of
some items increased, and she altered her market basket by purchasing
a different fruit.  In all three weeks, we assumed that she attained
the same level of satisfaction from the consumption of these food
items. 



                                    Table IV.1
                     
                       Hypothetical Shopper's Grocery Bills
                               Over a 3-week Period

              Week 1                   Week 2                    Week 3
     ------------------------  -----------------------  ------------------------
Gro
cer
y                Price  Weekl             Price  Weekl              Price  Weekl
ite                per      y               per      y                per      y
m     Quantity    item   cost  Quantity    item   cost   Quantity    item   cost
---  ---------  ------  -----  --------  ------  -----  ---------  ------  -----
Ban          5   $0.20  $1.00         5   $0.20  $1.00          0   $0.20     $0
 an
 as
Blu          0    1.99      0         0    1.99      0      1 box    1.49   1.49
 eb
 er
 ri
 es
Cer      1 box    3.89   3.89     1 box    3.89   3.89      1 box    4.19   4.19
 eal
Mil    1 quart     .99    .99   1 quart    1.05   1.05    1 quart    1.05   1.05
 k
Ora    2 small     .95   1.90   2 small     .95   1.90    2 small     .99   1.98
 nge      cans                     cans                      cans
 ju
 ic
 e,
 fr
 oz
 en
Pea      1 bag    1.29   1.29     1 bag    1.35   1.35      1 bag    1.35   1.35
 s,
 fr
 oz
 en
Pre          1    2.49   2.49         1    2.49   2.49          1    2.49   2.49
 pa
 re
 d
 di
 nn
 er
 ,
 fr
 oz
 en
Din  1 package    1.49   1.49         1    1.50   1.50  1 package    1.50   1.50
 ner                            package
 ro
 ll
 s
Lea     1 head     .69    .69    1 head     .69    .69     1 head     .69    .69
 f
 le
 tt
 uc
 e
Tom          1     .89    .89         1     .89    .89          1     .99    .99
 ato
Chi  1 package    3.59   3.59         1    3.59   3.59  1 package    3.59   3.59
 ck                             package
 en
 br
 ea
 st
 s
Ham    1 pound    1.59   1.59   1 pound    1.59   1.59    1 pound    1.59   1.59
 bu
 rg
 er
Pot          2     .25    .50         2     .25    .50          2     .25    .50
 at
 oe
 s
Ric  1 package    1.79   1.79         1    1.89   1.89  1 package    1.89   1.89
 e,                             package
 fl
 av
 or
 ed
================================================================================
Tot   19 items     n/a  $22.1  19 items     n/a  $22.3   15 items     n/a  $23.3
 al                         0                        3                         0
--------------------------------------------------------------------------------


   (See figure in printed
   edition.)

Legend:  n/a = Not applicable

Source:  Hypothetical example developed by GAO. 

The values for three price index formulas--Laspeyres, Paasche, and
Fisher Ideal--that would be derived for our hypothetical illustration
are provided in table IV.2. 



                               Table IV.2
                
                  Laspeyres, Paasche, and Fisher Ideal
                 Formulas Index Values for Hypothetical
                              Illustration

                             Index values using three basic formulas
                           -------------------------------------------
Week                           Laspeyres        Paasche   Fisher Ideal
-------------------------  -------------  -------------  -------------
1                                  100.0          100.0          100.0
2                                  101.0          101.0          101.0
3                                  103.2          100.9          102.0
----------------------------------------------------------------------
Source:  GAO. 

The following descriptions are simplified to show how the indexes
differ conceptually.  Although the basic concepts presented are
accurate, the actual calculations would be substantially more
complex. 


--------------------
\1 Price index formulas are named for the persons who developed them. 
The index formulas and the theoretical discussions about them can be
found in W.E.  Diewert, "The Theory of the Cost-of- Living Index and
the Measurement of Welfare Change" Price Level Measurement, ed.  W.E. 
Diewert (New York:  North Holland, 1990), pp.  79-147. 

\2 This description is true as long as consumer preferences for goods
and services are homothetic (i.e., expenditure shares among goods and
services stay constant when income changes).  If preferences are not
homothetic, there are different cost-of-living indexes corresponding
to different income and price situations, and the Laspeyres and
Paasche indexes do not serve as upper and lower bounds on the same
cost-of-living index. 


   LASPEYRES INDEX FORMULA
-------------------------------------------------------- Appendix IV:1

An index calculated with a Laspeyres index formula measures price
changes in relation to the base period's market basket and thereby
"fixes" the market basket by holding the items in it constant.  It
calculates what that market basket would cost in later periods, even
if some of the items were no longer purchased. 

For our hypothetical shopper, the Laspeyres index formula uses what
she purchased in the first week as the base of the calculation--the
fixed market basket.  All comparisons are made with respect to the
quantities of items she purchased and the prices she paid for them in
the first week.  Since she purchased the same items in the second
week, a Laspeyres index would divide her grocery bill for the second
week by the first week's bill and obtain an index value of 101.0, as
shown in table IV.2. 

Since the shopper bought blueberries instead of bananas in the third
week, the third week's grocery bill cannot be simply divided by the
first week's bill.  An adjustment must be made to reconstruct the
first week's fixed market basket by subtracting the cost of the
blueberries and adding the cost of the bananas as if she had
purchased bananas in the third week.  This is done to make the third
week's market basket identical to the first week's market basket.  A
Laspeyres index value of 103.2 is obtained by dividing the adjusted
third week's grocery bill by the first week's bill. 


   PAASCHE INDEX FORMULA
-------------------------------------------------------- Appendix IV:2

An index calculated with a Paasche index formula measures price
changes for a market basket containing what consumers are currently
purchasing, rather than what they purchased in a previous period. 
This index assumes that consumers' tastes and preferences change to
maintain a constant level of satisfaction and compares the cost of
the consumers' current market basket with what it would have cost to
buy this basket of goods and services in an earlier period. 

As shown in table IV.2 for the hypothetical illustration, the Paasche
index value (101.0) is the same as the value obtained with the
Laspeyres index formula (101.0) in the first 2 weeks because our
hypothetical shopper purchased the same items.  However, the
difference between the Paasche and the Laspeyres formulas is evident
in the third week when the shopper purchased blueberries in place of
bananas.  Instead of pricing bananas as was done in the Laspeyres
calculation, blueberries remain in the market basket for the Paasche
calculation and are priced as if they had been purchased in the first
week.  A Paasche index value of 100.9 is obtained by dividing the
third week's grocery bill by an amount that reflects the third week's
market basket priced with prices charged during the first week. 

Because the items, quantities, and prices changed between the second
and third weeks, the Paasche index value for the third week cannot be
compared with the Paasche value for the second week.  The difference
between these 2 weeks cannot be referred to as a price change because
the shopper changed the type and quantity of fruit she purchased. 
The index numbers for the third week, calculated with a Paasche index
formula, can be compared only with the base period--the first week. 
(Also, the index number for the second week can be compared only with
the base period.)


   FISHER IDEAL INDEX FORMULA
-------------------------------------------------------- Appendix IV:3

The Fisher Ideal index formula uses the Laspeyres and Paasche index
values and, therefore, does not allow comparisons between adjacent
periods.  To allow comparisons of index values between adjacent
periods, an adjustment--chaining--can be made to the Fisher Ideal
index values.  In this section, we first describe a Fisher Ideal
index with the illustration of our shopper, and we then describe
chaining with the Fisher Ideal index.  Both the Fisher Ideal index
and its chain are superlative price indexes. 

A Fisher Ideal index number is the square root of the product of the
Laspeyres index number multiplied by the Paasche index number.  For
example, in the third week of our illustration, the Fisher Ideal
index number of 102.0 is the square root of the product of 103.2
(Laspeyres) and 100.9 (Paasche).  The result of the Fisher Ideal
index is a geometric mean, which differs from an arithmetic mean, or
average.  For example, the third week's arithmetic mean of 102.1 is
103.2 (Laspeyres) plus 100.9 (Paasche) divided by 2.\3

Because the Fisher Ideal index incorporates the Paasche index value
in its calculation, the limitations of the Paasche also transfer to
the Fisher.  For example, the comparison of the values for the third
week with the values of the second week cannot be interpreted as a
price change because the shopper purchased blueberries instead of
bananas.  As with the Paasche, the index numbers for the second and
third weeks can only be compared with the base period--the first
week--and not to each other. 

The chained Fisher Ideal index is the square root of the product of
the chained Laspeyres index number multiplied by the chained Paasche
index number.  A chained index "chains" period-to-period indexes back
to the reference period (i.e., week 1 in the hypothetical
illustration).  Because they are chained to each other, comparisons
can be made between any sets of index number values. 

The Laspeyres and Paasche chained indexes are calculated
similarly--the previous chained index value is multiplied by a price
relative, which is a ratio of the previous and current unchained
index values.  For example, to chain the Laspeyres index numbers
between the first and second weeks in our hypothetical illustration,
the chained Laspeyres index number for the first week (100.0), which
is also the base, is multiplied by the price relative of 1.01, which
is the ratio between the Laspeyres index numbers for the first and
second weeks (101.0 divided by 100.0).  To calculate the chained
value for the third week, the chained value for the second week
(101.0) is multiplied by the price relative for the third week
(1.02).  These same procedures are followed to obtain the chained
Paasche index values.  Then, to obtain the chained Fisher Ideal index
formula values, the square root of the product of the chained
Laspeyres index number is multiplied by the chained Paasche index
number.  For example, the third week's chained Fisher Ideal index
number of 102.0 is the square root of the product of 103.2 (chained
Laspeyres) and 100.9 (chained Paasche). 


--------------------
\3 A geometric mean treats price increases and decreases
symmetrically, whereas an arithmetic mean, as used in a Laspeyres
index, gives price increases more influence, thereby showing a faster
rate of price change. 


   OBSERVATIONS
-------------------------------------------------------- Appendix IV:4

The index value derived from the Laspeyres index formula attained the
highest value of the three index values by the third week, supporting
economists' views that it provides an upper bound for estimating the
cost of living.  As shown in table IV.2, the Paasche index value was
the lowest in the third week in comparison with the first week. 
Assuming that the shopper was equally satisfied with either fruit
selection, the value as derived from the Paasche suggests that it
provides a lower bound for estimating the cost of living. 

The superlative index values, as represented in our hypothetical
illustration by the Fisher Ideal index, indicate that by using the
geometric mean of the corresponding Laspeyres and Paasche indexes,
one obtains an index value that resides between them. 




(See figure in printed edition.)Appendix V
COMMENTS FROM THE BUREAU OF LABOR
STATISTICS
========================================================== Appendix IV



(See figure in printed edition.)



(See figure in printed edition.)




(See figure in printed edition.)Appendix VI
COMMENTS FROM THE COUNCIL OF
ECONOMIC ADVISERS
========================================================== Appendix IV

See comment 1. 

See p.  28. 

See p.  1. 

See comment 2. 

Now on pp.  22-24. 

See p.  1. 



(See figure in printed edition.)

See comment 3. 

See p.  28. 


The following are GAO's comments on the Council of Economic Advisers'
(CEA) letter dated August 8, 1997. 


   GAO COMMENTS
-------------------------------------------------------- Appendix IV:5

1.To prevent any misunderstanding, we want to clarify that we are
recommending that the expenditure weights be updated more frequently
than every 10 years or so.  We are not recommending a specific time
interval (i.e., 5 years ) as CEA suggested. 

2.We agree that more frequent updating does not fix the bias arising
from the fixed market basket structure of the CPI.  However, the
broad array of economic literature that we reviewed supported the
proposition that the CPI would be improved by more frequent updating
of expenditure weights.  But economic theory is not available to
guide the choice of a specific update interval for the CPI.  We have
added a statement explaining that we did not identify any theoretical
guidance on how often expenditure weights should be updated. 

3.In our draft report, we did not acknowledge that we disagree with
the conclusion of the Greenlees paper because, for the purposes of
this report, BLS indicated that there was a relationship between
market basket age and measured inflation.  BLS estimated that the
growth in the CPI could be reduced annually anywhere from 0 to 0.2
percentage point if the expenditure weights were updated on a 5-year
basis.  In reaching this position, BLS took into account the
information and conclusions drawn in the Greenlees paper. 




(See figure in printed edition.)Appendix VII
COMMENTS FROM THE OFFICE OF
MANAGEMENT AND BUDGET
========================================================== Appendix IV

See pp.  27 and 28. 

See comment 1. 



(See figure in printed edition.)

See comment 2. 

See comment 3. 


The following are GAO's comments on the Office of Management and
Budget's (OMB) letter dated August 12, 1997. 


   GAO COMMENTS
-------------------------------------------------------- Appendix IV:6

1.As suggested by OMB, we obtained the views of Bureau of Economic
Analysis (BEA) officials on the potential consequences for BEA's work
if the CPI expenditure weights were updated more often.  The BEA
Director stated that the content of Personal Consumption Expenditures
(PCE) and the sources of information used to construct it make the
potential effect unclear.  BEA primarily uses CPI data to adjust the
dollar amounts of many items in the PCE.  The Director said that the
goods and services in the PCE do not all correspond to those in the
CPI on a one-to-one basis\1 and that, in adjusting items in the PCE,
BEA uses many different price indexes in addition to the CPI. 

The BEA Director said he was more concerned with the potential effect
of an experimental CPI that BLS began publishing in April 1997.  To
address lower-level substitution bias, BLS is using a different
formula on an experimental basis to aggregate the 94,000 items for
which prices are collected each month into the 206 item strata.  (See
footnote 14 in the background section of this report.) This
experimental index does not involve the subject of this
report--weighting the 206 item strata for aggregation.  The Director
said that if and when BLS introduces this change on a permanent
basis, changing the aggregation of items at the lower level is more
likely to affect BEA's work than changing the frequency of
expenditure weights of the CPI. 

2.We agree with the clarifications that OMB suggested and have made
them throughout the report.  The changes make clear that the 0.1
percentage point and the 0.2 percentage point are each an annual
reduction in the growth of the CPI, and that the estimates of the
effect of such reductions on the federal budget are cumulative
totals. 

3.The dollar estimates that CBO provided to us and that were included
in our draft report factored in the rounding rules for income tax
brackets.  As suggested by OMB, we discussed with CBO whether it
should provide additional estimates without these rounding rules.  In
essence, the CBO staff with whom we spoke said that setting aside the
rounding rules would not produce estimates that differed much from
the estimates in the draft.  According to the staff, the rounding
rules would affect which year departed from the trend over the number
of years studied, but the cumulative dollars over those years would
not change.  For that reason, we did not ask CBO to produce
additional estimates; therefore, the estimates that appeared in the
draft report also appear in this report. 



(See figure in printed edition.)Appendix VIII

--------------------
\1 We described the differences in a 1996 letter to Senator Daniel
Patrick Moynihan.  See Alternative Poverty Measures (GAO/GGD-96-183R,
Sept.  10, 1996).  See enclosure I to the letter that compares the
source data used to construct the PCE and the CEX, which is used to
develop the expenditure weights in the CPI. 


COMMENTS FROM THE BOARD OF
GOVERNORS OF THE FEDERAL RESERVE
SYSTEM
========================================================== Appendix IV

See p.  27. 



(See figure in printed edition.)

Now pp.  12 and 13. 

See pp.  12 and 13. 

See p.  28. 

See comment 1. 

See comment 2. 


The following are GAO's comments on the Federal Reserve's letter
dated July 31, 1997. 


   GAO COMMENTS
-------------------------------------------------------- Appendix IV:7

1.We agree with the Federal Reserve's comment that the recent paper
by Shapiro and Wilcox\1 supported the conclusion in the Greenlees
paper that more frequent updating of expenditure weights will not
reduce upper-level substitution bias.  However, there was a certain
data limitation identified in the Greenlees paper, which is probably
applicable to the Shapiro and Wilcox paper.  This data limitation
raised questions in our minds about the conclusions Greenlees and
Shapiro and Wilcox drew from their comparisons derived from these
data.  Each paper compared a price index that was based on 1982
through 1984 expenditure data with a price index that was based on
1986 and later expenditure data.  We believe that what Greenlees
identified as a potential explanation for the contrasts between the
two price indexes--the incorporation of the 1980 census-based
geographic samples into the CEX in 1986--could have also affected the
Shapiro and Wilcox results, which was a factor their paper did not
consider.  We should also point out as well that BLS, for purposes of
this report, estimated that the growth in the CPI could be reduced
from 0 to 0.2 percentage point per year with a 5-year update of
expenditure weights.  In addition, Shapiro and Wilcox indicated that
the trends they found in their research study were not the trends
they expected.  Referring to these as "elusive empirical puzzles,"
they called for additional research in this area of bias in the CPI. 

2.We talked with BEA's Director and its Chief Statistician about the
Federal Reserve's comment concerning the revision history of its
chained price index.  We specifically asked about BEA's use of the
"Laspeyres tail" in its chained price index and if BEA had any
estimates that are based on its experience with this methodology that
would indicate how much routine updating of expenditure weights might
matter.  (Since the index with the Laspeyres tail used fixed weights
and the revised chained price index used a Fisher Ideal formula,
which is more reflective of current consumer spending, the amount of
difference between the two price indexes could indicate the level of
effect that would occur with a more frequent updating of expenditure
weights.)

The Chief Statistician said that he had looked at the difference
between the two price indexes and that using the Laspeyres tail
appeared to have a very small effect, but he had not calculated the
size of its effect apart from other factors that were also changed
when the index was revised.  He believed these other factors probably
had made a greater contribution to the difference between the two
indexes than changing the price index formula. 


--------------------
\1 Matthew D.  Shapiro and David W.  Wilcox.  "Alternative Strategies
for Aggregating Prices in the CPI," February 10, 1997. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix IX

Kathleen K.  Scholl, Senior Economist
Anthony Assia
Richard Krashevski
Loren Yager



RELATED GAO PRODUCTS
============================================================ Chapter 0

Consumer Price Index:  Cost-of-Living Concepts and the Housing and
Medical Care Components (GAO/GGD-96-166, Aug.  26, 1996). 

Economic Statistics:  Status Report on the Initiative to Improve
Economic Statistics (GAO/GGD-95-98, July 7, 1995). 

Economic Statistics:  Measurement Problems Can Affect the Budget and
Economic Policymaking (GAO/GGD-95-99, May 2, 1995). 

Prescription Drug Prices:  Official Index Overstates Producer Price
Inflation (GAO/HEHS-95-90, Apr.  28, 1995). 

Developing a Consumer Price Index for the Elderly (GAO/T-GGD-87-22,
June 29, 1987). 

Stabilizing Social Security--Which Wage Measure Would Best Align
Benefit Increases With Revenue Increases?  (GAO/IMTEC-85-13, Aug. 
27, 1985). 

Funds Needed to Develop CPI Quality Control System (GAO/GGD-83-32,
Apr.  1, 1983). 

A CPI for Retirees Is Not Needed Now But Could Be in the Future
(GAO/GGD-82-41, June 1, 1982). 

A Consumer Price Index for Retirees and Alternatives for Controlling
Indexing (Testimony, Apr.  20, 1982). 

Measurement of Homeownership Costs in the Consumer Price Index Should
Be Changed (GAO/PAD-81-12, Apr.  16, 1981). 

Alternatives for Modifying the Indexation of Federal Programs
(Testimony, Mar.  10, 1981). 

*** End of document. ***