Chained CPI is one of many ways to approximate the impact to consumers' pocketbooks of rising or falling prices. Although many economists believe that it is an improvement over conventional CPI measures, some lawmakers are hesitant to entertain it due to its impact on fixed-income seniors.

During the recent federal budget and debt ceiling talks in Congress, the term "chained CPI" was raised on both sides of the aisle as a possible way to reduce the deficit. The change in accounting procedures would affect many federal coffers, including how much is paid out in future Social Security benefits and the amount of tax revenue generated.

Chained vs. Conventional CPI
In order to understand chained CPI, you first need to know what the conventional CPI is. The consumer price index is an economic measure used to assess the rate of inflation and changing price levels. It takes a virtual "basket" of consumer goods, including groceries, housing, gasoline and clothing, and tracks the average prices of the basket components over time. An overall rise in the basket price indicates increasing inflation in the economy. The federal government uses the CPI to index certain benefits, such as Social Security payments, as well as to set the boundaries of income tax brackets.

Many economists over time have stated that the CPI does not accurately assess the reality of today's economy. While the appropriate makeup of the basket of consumer items and the weighting of each item are hotly debated, the main concern is that the CPI does not account for changes in demand when prices rise and fall. If, for example, the price of canned salmon goes up, many consumers will simply switch to the less-expensive canned tuna, rather than buying less salmon or going without. This type of substitution lessens the impact of inflation on consumers. Chained CPI attempts to address this economic reality. On average, the chained CPI is less than the conventional CPI by 0.25 to 0.3 percentage points. The Bureau of Labor Statistics has been tracking chained CPI since 2002.

Chained CPI: a Hot Topic
So why is chained CPI such a hot topic in politics? The Moment of Truth project, a task force cochaired by former Sen. Alan Simpson and former White House Chief of Staff Erskine Bowles, released a paper estimating that the government could save roughly $300 billion over 10 years by adopting chained CPI. Future Social Security payments would be reduced under the new measure as would pension payments to federal retirees. Income tax brackets wouldn't increase as much, pushing more taxpayer income into higher tax brackets and generating more federal tax revenue.

Many liberal politicians are opposed to adopting chained CPI as it results in less income to retirees, although others see it as more palatable than cutting current benefits. The National Active and Retired Federal Employees Association suggests that neither conventional nor chained CPI is a good measure of inflation because neither takes into account seniors' health care costs.

To the extent that chained CPI (or any other inflation measure) perfectly reflects the economic reality and the impact of rising prices on consumers' bottom lines, income or tax changes indexed using that measure have no net impact on those consumers. Perfect inflation indexing simply keeps people in the same position they were in before, regardless of whether prices rise or fall. The more the measure deviates from economic reality, the greater the impact on consumers. If chained CPI results in a more fine-tuned measurement than conventional CPI, the federal government can benefit substantially while not affecting people's net incomes.

Although the subject of chained CPI has been raised in fiscal negotiations several times, it has been removed from consideration in the recent fiscal cliff talks. It may, however, be back on the table when the debt ceiling discussions begin in the first quarter of 2013.

The Bottom Line
Chained CPI is one of many ways to approximate the impact to consumers' pocketbooks of rising or falling prices. Although many economists believe that it is an improvement over conventional CPI measures, some lawmakers are hesitant to entertain it due to its impact on fixed-income seniors.

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