I think we ought to set aside the consumer price index. The reason I say that is that the PCE deflator is far more usable for analyzing what is really going on. The owners' equivalent rent component in the CPI is 20 percent of the total index. Now, owners' equivalent rent is going to start to accelerate unless I misread how asset prices interact with consumer prices. The reason is that the ratio of owners' equivalent rent to the value of housing has been going down continuously, and the implicit rate of return that that is suggesting cannot credibly be expected to continue on a prolonged basis. So the little "pop" we saw in owners' equivalent rent in the most recent CPI is probably a harbinger of a slightly stronger number there.

The reason the PCE deflator is a better indicator in my view is that it incorporates a far more accurate estimate of the weight of housing in total consumer prices than the CPI. The latter is based upon a survey of consumer expenditures, which as we all know very dramatically underestimates the consumption of alcohol and tobacco, just to name a couple of its components. It also depends on people's recollections of what they spent, and we have much harder evidence of that in retail sales data, which is where the PCE deflator comes from. Why we should look at data based on a distorted sample when we have a universe whose data are more accurate is beyond me. The reasons that are given theoretically are that we want to measure urban or suburban consumer prices and that's not what gets picked up in the total. It would be so easy to make a simple adjustment in the aggregate data to cover only the urban component by using appropriate ratios if we want to do that. That is, we could use the base universe of what is consumed to give us our weights, but that is not what the CPI does. So if I had my way, the CPI would be abolished for all uses other than labor union contracts, Social Security benefits, and all the other uses that would create an undue amount of political noise if we tried to change them.  It's not statistical noise that I am talking about at the moment.  In sum, I think we have to be careful about any reading of inflation trends from the CPI.

As we move closer to price stability, the necessity of measuring prices accurately has become an especial challenge. Biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, a debate has emerged over whether our economies are moving toward price deflation...

In thinking about the problems of price measurement, a distinction must be made between the measurement of individual prices, on the one hand, and the aggregation of those prices into indexes of the overall price level, on the other. The notion of what we mean by a general price level--or more relevantly, its change--is never unambiguously defined. ...

It is the measurement of individual prices, not the aggregation of those prices, that is so difficult conceptually. At first glance, observing and measuring prices might not appear especially daunting. After all, prices are at the center of virtually all economic transactions. But, in fact, the problem is extraordinarily complex. To be sure, the nominal value--in dollars or deutsche marks, for example--of most transactions is unambiguously exact and, at least in principle, is amenable to highly accurate estimation by our statistical agencies. ...

But when the characteristics of products and services are changing rapidly, defining the unit of output, and thereby adjusting an item's price for improvements in quality, can be exceptionally difficult. These problems are becoming pervasive in modern economies as service prices, which are generally more difficult to measure, become more prominent in aggregate price measures. One does not have to look to the most advanced technology to recognize the difficulties that are faced. To take just a few examples, automobile tires, refrigerators, winter jackets, and tennis rackets have all changed in ways that make them surprisingly hard to compare to their counterparts of twenty or thirty years ago.

The Boskin commission, along with most other estimates of bias in the U.S. CPI, have taken a microstatistical approach, estimating separately the magnitude of each category of potential bias. Recent work by staff economists at the Federal Reserve Board has added corroborating evidence of price mismeasurement, using a macroeconomic approach that is essentially independent of the microstatistical exercises. Specifically, employing disaggregated data from the national income and product accounts, this research finds that the measured growth of real output and productivity in the service sector is implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained. Indeed, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. It is simply not credible that firms in these industries have been becoming less and less efficient for more than twenty years. Much more reasonable is the view that prices have been mismeasured and that the true quality-adjusted prices have been rising more slowly than the published price indexes. Properly measured, output and productivity trends in these service industries might be considerably stronger than suggested by the published data. Assuming, for example, no change in productivity for these industries would imply a price bias consistent with the Boskin commission findings.

In other words, there is almost a 100 percent probability that we are overcompensating the average social security recipient for increases in the cost of living, and almost a 100 percent probability that we are causing the inflation-adjusted burden of the income tax system to decline more rapidly than I presume the Congress intends.  A major reason for this is that consumers respond to changes in relative prices by changing the composition of their actual marketbasket. At present, however, the marketbasket used in constructing the CPI changes only once every decade or so. Moreover, new goods and services deliver value to consumers even at the relatively elevated prices that often prevail early in their life cycles; currently, that value is not reflected in the CPI.

Significant innovations, such as the personal computer, the cellular telephone, and the heart bypass operation create value for consumers, even at their typically high initial prices; moreover, this value is even greater at the much lower prices that often prevail when new products are, in fact, introduced into the CPI. A true cost-of-living index would reflect this value and its implication for the true rate of growth of the cost of living. The CPI does not reflect it, and accordingly fails to capture a significant offset to price rises in other products.