A Measurement Lesson from Social Security

Friday, October 16, 2009

132261_rulerSocial Security recipients will get no cost-of-living adjustment (COLA) next year because the trailing one-year Consumer Price Index change was negative. This fact brought to mind the commonly used twelve-month changes to measure economic and financial results. In normal times, such analysis is appropriate. A twelve-month comparison removes the monthly and quarterly noise and avoids the need for seasonal adjustment. However, it is misleading now…

Twelve-month changes are dependent on two numbers: the latest and the one twelve months ago. So long as the numbers are representative of a fairly smooth trend, they are useful. Where they go haywire is when the numbers gyrate widely in the period. This is what happened over 2008-2009.

A good example is the CPI. The graph below shows the index used by the Social Security Administration to calculate its COLA (*). For the twelve months ended September 2009, the index is down. Now look at what happens to the 12-month reading month by month going forward, assuming the index, itself, remains unchanged. It surges up as the beginning month values drop. These new readings will not mean inflation is suddenly rising. It’s just the arithmetic effect of walking through the numbers.

CPI-W change

The lesson here can be applied to many of the indicators presented on a 12-month  basis: housing, retail sales, income, employment, etc. Areas where we have been seeing double-digit drops are about to make an about face. The economy dropped so quickly at the end of 2008 that much lower starting points will soon hype the 12-month percentage change results. Just like with the CPI, however, the much better numbers won’t represent a sudden growth surge – just an easier comparison.

(*) The Social Security COLA is based on the change in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) from the third quarter of one year to the third quarter of the next. From 2008 to 2009, that change was -2.1%.

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