What is Chain-Weighted CPI?
The chain-weighted CPI, or chained CPI, is another measure of Consumer Price Index (CPI) which accounts for changes in consumer spending habits to provide a more accurate picture of the cost of living based on the goods consumers actually buy.
Key points to remember
- The chain-weighted CPI takes purchasing decisions into account in real terms to provide a more accurate picture of the cost of living.
- The chain-weighted CPI can capture both general changes in spending, as consumer preferences change, and substitution effects, as relative prices change.
- Chain-weighted CPI adjustments make it a better measure of the cost of living, but a less accurate measure of inflation.
- In 2017, the chain-weighted CPI was replaced by the regular CPI in establishing federal income tax brackets.
Understanding Chain-Weighted CPI
The chain-weighted CPI for each month takes into account changes in consumer preferences and product substitutions due to changes in the relative prices of goods produced by consumers. Therefore, this measure is considered a more accurate measure of the cost of living than the traditional fixed-weighted CPI. This is simply because it adjusts based on the range 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 current indicator and a less precise measure of inflation.
United States Bureau of Labor Statistics publishes the chain-weighted CPI for each month as well as its other regular price and inflation reports. IPC-U, also known as the regular all-items CPI index, and other similar indices are calculated by collecting the monthly prices of a basket of consumer goods that are relatively constant in composition and weight from one month to the next. to another, with updates only every few years. In contrast, the monthly basket of consumer goods whose prices are used to calculate the chain CPI is also updated monthly to reflect the mix of goods that consumers actually purchased during that month.
These adjustments are intended to take into account two elements that a fixed-basket CPI would ignore.
- First, over time consumer preferences for goods change and the type and quality of goods available generally improve as technology advances. By adding new goods introduced and adjusting the weights of existing goods to better map trends in consumer spending on different types of goods, the chained CPI can capture these effects.
- Second, consumers tend to adjust their buying behavior within and between different categories of goods based on relative price changes between those goods. For example, when the price of ground beef relative to chicken increases, consumers are likely to buy more chicken and less beef. This is known as the substitution effect. Since consumers substitute, the true cost of their total purchases will tend to be more stable than a price index of a fixed basket of goods with a fixed weight would imply.
According to the BLS, these adjustments make the chain-weighted CPI a closer approximation to a Cost of life index than other CPI measures.
However, this improvement in measuring the real costs of consumer spending choices introduces several limitations. The BLS points out that because these adjustments take longer and rely on estimates of consumer behavior that must be updated and revised later, the chain-weighted CPI is a much less current indicator than the regular CPI. Monthly chain-weighted CPI figures are updated and revised retroactively each month, with a final index released only 12 months after the fact. This may make it less useful as a real-time indicator of the cost of living. The regular CPI is considered the final estimate for each month it is released.
Additionally, while the chain-linked CPI may be a better indicator of the cost of living, these same adjustments also make it a weaker indicator of inflation. Inflation is the decline in purchasing power of a currency unit over time, which is a separate 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 usefulness of the index for measuring decline in purchasing power, since many changes in consumer buying decisions may themselves be wholly or partly driven by changing purchasing power or consumer expectations in this regard. Despite this, the chain-weighted CPI is often considered a measure of inflation.
Finally, the total effect of chain-weighted CPI adjustments is that it tends to be more stable and exhibit a slower rate of increase in the cost of living (or, as is often misinterpreted, the rate of inflation) over time relative to the regular CPI. . This can be seen as a feature or a drawback of the chain-weighted CPI depending on the interests and incentives of the person reporting and using the index. In particular, from the government’s perspective, the use of a chain-weighted CPI rather than a regular CPI to make cost-of-living adjustments to public benefit payments and marginal tax rate brackets result in lower payouts to beneficiaries and higher effective tax rates as a tax rate, respectively. taxpayers’ incomes will slide into higher tax brackets faster than upward bracket adjustments will be made.
Example of chain-weighted CPI
Consider the impact of two similar and substitutable products, beef and chicken, in the 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 rose to $6/lb while the price of chicken rose to $2/lb. While both prices have increased, the price of beef relative to the price of chicken is higher (beef now costs three times the price of chicken instead of twice).
Mrs. Smith therefore adjusts her spending habits due to the higher price of beef and buys three pounds of chicken but only one pound of beef to cushion the impact the higher 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 the primary CPI to adjust for incremental increases in income tax brackets. By switching to this measure, increases in tax bracket adjustments will be comparatively smaller each year. This shift to chain-weighted CPI should push more citizens into higher tax brackets over time, thereby increasing the taxes they owe and, therefore, increasing the tax revenue collected by the Internal Revenue Service (IRS).
The year-to-year change will likely be one percentage point or less in any given year, but there is a significant difference over time. For example, between January 2000 and July 2022, the primary CPI increased by 74.4%, but the chain-weighted CPI only increased by 64.8%.
For taxpayers whose increases are indexed to the primary CPI, this change may eventually cause them to pay more taxes in a higher bracket even if they don’t feel much wealthier. As inflation accelerates, this effect will become more pronounced, meaning that more taxpayers will begin to feel the effects of higher taxes in addition to paying more for the goods and services they purchase.
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