Debt deals could hurt military cost of lviing adjustment

July 28, 2011 

Military retirees, Social Security recipients and others drawing federal payments were tempted to grumble at Congress or the White House when the past two Januarys brought no cost-of-living adjustment.

The real culprits were a deeply distressed economy, which drove prices down, and a logical process, set up 40 years ago, to track inflation and adjust federal payments to protect their purchasing power.

Those who did complain about absent COLAs might soon have a more legitimate reason to grouse: a new yardstick for setting COLAs called the Chain Consumer Price Index for All Urban Consumers (Chain CPI-U).

First, let's review why COLAs stopped for two years.

Beginning in the last quarter of 2008, the cost of goods and services fell sharply while housing and financial markets collapsed. Yet the last COLA, in January 2009, had been shaped by price data collected months earlier after gasoline prices had hit new highs. So federal entitlements jumped 5.8 percent, the largest bump in 25 years, as prices slid across the marketplace.

The tool long used by the Bureau of Labor Statistics to track inflation and set COLAs is the Consumer Price Index of All Urban Wage Earners and Clerical Workers (CPI-W). After the 2009 increase, no COLA could be paid until prices for a market basket of goods and services surpassed levels reported in the third quarter of 2008, and used to set the 5.8 percent COLA.

The CPI-W only cleared that milestone in January 2011. Through June this year, CPI-W shows retirees in line for at least a 3.2 percent COLA next January, with inflation from July through September still to be measured.

For traditional indices like the CPI-W, the Bureau of Labor Statistics creates a market basket, using spending patterns for the covered population, and tracks inflation over time based on the overall change in the price of the basket.

The knock on such indices is they overstate inflation through "substitution bias," ignoring how consumers respond to price changes. For example, if a family spent $100 last month on beef and the price doubles, their cost of living won't rise by $100, economists contend. Instead, the family will buy less beef and more of something else. CPI-W assumes consumers buy the same basket of goods regardless of price.

This issue surfaced 15 years ago in a study of the consumer price index known as the Boskin Commission report. Since then the Bureau of Labor Statistics changed how it calculates CPI-W and another index, Consumer Price Index for All Urban Consumers (CPI-U), which is used to adjust tax brackets and poverty thresholds. But the Bureau of Labor Statistics changes could only address substitution bias within product categories, to capture how consumers might buy more of a regional brand of hot dog versus a more popular national brand.

Economists say CPI-W and CPI-U still ignore "upper-level substitution," which occurs across product category -- such as when consumers decide to buy more apples when the price of oranges rises. The Chain CPI-U, which the Bureau of Labor Statistics established in 2002, addresses this, tracking not only prices but changes to a representative market basket month to month. It then "chains" months together to calculate overall cost of living.

Adopting the Chain CPI to adjust entitlements has been recommended by every group looking for ways to address the federal debt crisis. That includes two bipartisan commission reports from last winter; Vice President Joe Biden's debt-relief working group of Republicans and Democrats, and the "Gang of Six" senators whose blueprint for combining spending cuts and tax increases won an enthusiastic nod from President Barack Obama.

Besides providing a more accurate measure of inflation, the Chain Consumer Price Index for All Urban Consumers would save roughly $300 billion in entitlement spending over the first decade after it took effect.

The Chain CPI-U has its critics, however. They argue the Chain COLA ignores the fact that quality of life is impacted if consumers replace products they prefer with products they can better afford.

For individual federal retirees and Social Security recipients, the Chain CPI would dampen current COLAs an average of .25 to .3 of a percentage point a year. If we assume over time CPI-W will show a 3 percent inflation rate, the C-CPI-U would be 2.7 percent to 2.75 percent. That difference is expected to grow more over time.

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