Chain-Weighted CPI: What it is, How it Works, Example

What Is Chain-Weighted CPI?

Chain-weighted CPI, or chained CPI, is an alternative measurement for the Consumer Price Index (CPI) that considers changes to consumer spending patterns to provide a more accurate picture of the cost of living based on the goods that consumers actually buy.

Understanding Chain-Weighted CPI

Chain-weighted CPI for each month accounts for changes in consumer preference and product substitutions due to changes in relative prices of goods made by consumers. Therefore, this metric is considered to be a more accurate gauge of cost of living than the traditional fixed-weighted CPI. This is simply because it adjusts based on the mix of goods that consumers actually buy rather than focusing on a fixed basket of goods. On the other hand these adjustments also make the chain-weighted CPI a less timely indicator and a less accurate measure of inflation.

The U.S. Bureau of Labor Statistics publishes the chain-weighted CPI for each month along with its other regular reports on prices and inflation. CPI-U, also known as regular of headline CPI, and other similar indexes are calculated by collecting the monthly prices of a basket of consumer goods that is held relatively constant in its composition and weighting from month to month, with updates only every several years. In contrast, the monthly basket of consumer goods whose prices are used to calculate chained CPI is also updated monthly to reflect the mix of goods that consumers actually bought in that month.

These adjustments are meant to account for two things that a fixed-basket CPI would ignore.

1. First, over time, both consumer preferences for goods change and the type and quality of goods available usually improves as technology advances. By adding new introduced goods and adjusting the weighting of existing goods to better map the patterns of consumer spending on different types of goods, the chained CPI can capture these effects.
2. Second, consumers tend to adjust their buying behavior within and across different categories of goods based on relative price changes among these goods. For example, when the price of ground beef relative to chicken rises, consumers are likely to buy more chicken and less beef. This is known as the substitution effect. Because consumers substitute, the actual cost of their total purchases, will tend to be more stable than a price index of a fixed basket of goods with fixed weight would imply.

According to BLS, these adjustments makes chain-weighted CPI a closer approximation to a cost-of-living index than other CPI measures.

However, this improvement in measuring the actual costs of consumers' spending choices introduces several limitations. BLS points out that, because making these adjustments takes more time and relies on estimates of consumer behavior that have to be updated and revised later, chain-weighted CPI is a much less timely indicator that regular CPI. Monthly chain-weighted CPI numbers are updated and revised retroactively each month, with a final index number only published 12 months after the fact. This can make it less useful as a real-time indicator of the cost-of-living. Regular CPI is considered to be the final estimate for each month that it is published.

Additionally, though chained CPI may be a better indicator of the cost of living, these same adjustments also make it a poorer indicator of inflation. Inflation is the decline in the purchasing power of a monetary unit over time, which is a distinct concept from the cost of living. Changing the composition and weighting of the basket of goods used to measure a price index to reflect actual changes in consumer behavior sabotages the index's usefulness for measuring the decline in purchasing power because many changes to consumer purchasing decisions may in whole or in part be themselves driven by changes in purchasing power or consumer expectations thereof. Despite this, chain-weighted CPI is often claimed to be a measure of inflation.

Finally, the total effect of chain-weighted CPI adjustments is that it tends to be more stable and show a slower rate of increase in the cost of living (or as it is often misconstrued, the rate of inflation) over time compared to regular CPI. This may be considered a feature or a drawback of chain-weighted CPI depending on the interests and incentives of the person reporting and using the index. In particular, from the government's point of view, using chain-weighted CPI rather than regular CPI to make cost of living adjustments to public benefits payments and marginal tax rate brackets results, respectively, in lower payments to beneficiaries and higher effective tax rates as tax payers incomes will creep in to higher tax brackets faster than upward adjustments to the brackets will be made.

Chain-Weighted CPI Example

Consider the impact of two similar and substitutable products—beef and chicken—in the shopping basket of Mrs. Smith, a typical consumer. Mrs. Smith buys two pounds of beef at $2 / lb. and two pounds of chicken at $1 / lb. A year later, the price of beef has risen to $6 / lb. while the price of chicken has risen to $2 / lb. While both prices have risen, the price of beef relative to the price of chicken is higher (beef is now three times the cost of chicken as opposed to two times).

Mrs. Smith, therefore, adjusts her spending pattern because of the higher price of beef and buys three pounds of chicken but only one pound of beef to cushion the impact that the rise in prices will have on her household budget.

Chain-Weighted CPI and Taxation

A US federal law passed in 2017 applied the chain-weighted CPI instead of primary CPI for adjusting the incremental increases in income tax brackets. By switching to this metric, the increases on tax bracket adjustments will be comparatively smaller each year. This move to chain-weighted CPI is expected to push more citizens into higher tax brackets over time, thereby increasing the taxes they owe and, in turn, increasing the tax revenue collected by the Internal Revenue Service (IRS).

The year-over-year change will likely be a percentage point or less over a given year, but there is a significant difference over time. For example, between January 2000 and July 2022, primary CPI increased by 74.4%, but chain-weighted CPI only increased by 64.8%.

For taxpayers with raises indexed to primary CPI, this change may eventually result in them paying more tax in a higher bracket despite not feeling significantly more wealthy. As inflation accelerates this effect will become more pronounced, meaning that more taxpayers will begin feeling the bite of higher taxes in addition to paying more for the goods and services they buy.