As consumers, we know when the price of the items we regularly consume goes up. When we pay more for a gallon of milk, our morning coffee, or to fill our gas tanks it's usually a mixed blessing. On the one hand, it makes us re-evaluate our budget, on the other hand, higher prices are sometimes offset by increased wages or "cost-of-living" increases.
Knowing when the increased cost of goods and services is the result of geopolitical events like storms or military conflicts and when they are the sign of macroeconomic conditions like inflation or new tax policies is one of the jobs for the U.S. Bureau of Labor Statistics. One way they measure the increase or decrease in the cost of goods and services in our economy is through the Consumer Price Index (CPI).
In this article, we’ll define what the Consumer Price Index is, how items are selected for the CPI, how the CPI is calculated and why it’s important. The article will also talk about the limitations of the CPI.
What is the Consumer Price Index (CPI)?
Before we define what the Consumer Price Index is, it would be useful to become familiar with the role of indexes. An index is the average of a group of similar, or related, items. For example, the concept behind an index fund is that the price of a share in the fund is based on an average of the securities that make up the index. One of the most well-known index funds is the Standard & Poor’s 500 Index (S&P 500). This index tracks the performance of 500 of the largest U.S. companies that are listed on either the New York Stock Exchange (NYSE) or the NASDAQ. Like a lot of indices, the S&P 500 Index is a weighted index. This means the companies selected are weighted based on their market capitalization. Market capitalization (or market cap) is calculated by multiplying the number of a company’s outstanding shares by its stock price per share. In the methodology used by the S&P 500 index, large-cap stocks (defined as a company with a market cap that is greater than $10 billion) are assigned a higher weight in the index than small cap stocks (defined as a company with a market cap between $300 million and $2 billion).
The consumer price index examines the average cost of a select group of consumer goods and services that range from food and beverages to smartphones and medical care. The Bureau of Labor Statistics updates the CPI monthly after recording the price of approximately 80,000 items. Like a stock market index fund, the items in the CPI are assigned different weights making the CPI a weighted average. This means that some items will be considered more important, and therefore a change in price up or down will have more effect on the index.
There are actually two Consumer Price Indexes. The first is the Consumer Price Index for All Urban Consumers (CPI-U) and the second is the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The CPI-U is generally seen as the more accurate of the two since it takes into account approximately 93% of the total U.S. population, including professionals, the self-employed and unemployed, and retirees.
Additionally, the CPI reports are broken down every month by the four major Census regions (Northeast, South, Midwest, and West) and by three major metropolitan areas (Chicago-Gary-Kenosha, Los Angeles-Riverside-Orange County and New York-Northern New Jersey-Long Island). Every other month the BLS reports CPI data for 11 additional metro areas and semi-annually an additional 13 metro areas.
Who is excluded in the CPI?
Those groups excluded from the CPI include citizens who live in what are defined as rural or nonmetropolitan areas, farm households, actively serving Military members, prisoners and patients in mental institutions.
How are items chosen for the CPI?
The products that comprise the CPI are derived from a series of separate, but related, samples. The first is the U.S. Census. The Bureau of Labor Statistics selects urban areas that will be used to collect data on prices. After that, the BLS conducts a telephone survey of approximately 14,500 families. The purpose of this survey is to determine what locations families in the target areas purchase various items. This then forms the basis for what outlets are visited by the BPI to track price changes. A specific item is then chosen based on the probability that an item will be purchased based on how much revenue that item contributes to that store’s revenue in that category.
The CPI is revised whenever there are considered to be a significant change in either consumer buying habits or population shifts. For example, in January 2018 the weighting of smartphones was adjusted to account for the speed at which technology is advancing and the improved quality they offer to consumers. In other words, they are deemed more important to the population group.
How the CPI is calculated
The BLS, either in person or by phone, surveys the locations and tracks the prices of the items that are included in the CPI. The price changes are weighted based on the importance of the item relative to the spending patterns of the specific population group. The weighted prices are added together and divided by the total number of items to create the CPI. However, that number by itself doesn't mean much. Like most statistics, it's important to understand what the number is based upon.
According to the BLS Handbook of Methods, the base period used for the CPI is currently the time period between 1982-1984. Therefore, when the CPI was 233.596 in July 2013, a standard interpretation was that a group of items that could have been purchased for $100 in 1982-1984 would have had a price tag of $233.60 in July 2013. However, the number that is reported every month only focuses on the percentage change between the previous month and/or the previous year. When looked at this way, the 233.596 number compared to a July 2012 CPI of 229.104. This meant the non-seasonally adjusted CPI from July 2012 to July 2013 was 2.0%.
The calculation is:
Current CPI – CPI from previous period = Index Point Change
To calculate the percent change
(Index Point Change / Previous Index) = x times 100 = Percent Change
In our example:
233.596 – 229.104 = 4.492
4.492/233.596 =0.019 x 100 = 1.9%
It is important to note that not all areas of the CPI are reported as a monthly change. Some categories may use a three-month moving average. This was the case with used cars and trucks until January 2018 when they switched to a single month price change.
Why is the CPI important?
- The CPI is considered one of our nation’s leading economic indicators. The CPI is widely used to measure inflation. This is when an increase in the price of goods and service is offset by the loss of purchasing power in a currency. In general, the U.S. Government considers a healthy inflation to be between 2-3%. When it starts rising above this, it may mean changes to fiscal or monetary policy may be needed. In the same way, businesses use the CPI to guide their pricing decisions and consumers use the CPI as a way of keeping their household budgets in line. The CPI is not the only measure of inflation, but it is generally considered the best measure of inflation when consumers are trying to get a sense of their purchasing power today versus purchasing the same amount of goods during a different time period.
- The CPI will show the effect of deflation in other economic series. You hear the phrase “adjusted for inflation” a lot. That shows another effect of the CPI. When it comes to metrics such as retail sales or hourly and weekly earnings, the price changes in the CPI help to make a translation of these numbers into inflation-free dollars. The CPI also shows how the consumer’s purchasing power is declining because of a deflation in the value of the dollar. As prices increase, the purchasing power of the dollar becomes less, proving the statement that a dollar doesn’t buy what it used to.
- The CPI adjusts dollar values. Although it is not a true cost-of-living index, the CPI, on a year-to-year basis, adjusts the cost-of-living payments for millions of Americans. Social security benefits, eligibility thresholds for certain government programs, and the cost-of-living increase that some employers will provide to their employees. According to the BLS, over 50 million U.S. citizens have some form of the cost-of-living adjustment (COLA) that is tied to the CPI. The CPI also prevents any inflation-induced increases in tax rates. It also defines the eligibility criteria for food stamp recipients, children who are eligible for free school lunches. Even some collective bargaining agreements use CPI data as a way of determining wage increases.
Limitations to the CPI
Anytime you are dealing with averages, you are going to have outlying data. The CPI reflects pricing information that is based on the experience of the relevant average household. Not only will this definition change over time, but it is also virtually impossible to presume that every price change will affect every citizen in the same way. Let's look at a couple of examples. Health care and medical expenses are items that are generally increasing in price every year. If you are a healthy, single individual with no dependents, your overall rate of inflation will be much less than for a family of five who has to devote a high percentage of their family budget to medical expenses. However, if the family that has high medical expenses also heats their home with solar energy, then they may be experiencing lower energy costs than the general population, which could help offset their higher medical costs. Conversely, the relatively healthy single individual with low medical expenses may live in an area where fuel costs are very high and so may be paying a higher percentage of their budget on those "staple" items.
Another limitation to the CPI comes in the way it weighs the importance of online outlets. According to the BLS as of 2017, about 8% of the prices quoted in the CPI sample came from online outlets. When you consider how rapidly consumers are turning to online shopping, particularly because of the ability to find lower prices online, even for items like groceries, it is reasonable to assume that the CPI may not be the best barometer of price changes.
Like any survey, the data is only as accurate as the respondents. Although most people would have little reason to give false information to a consumer survey, particularly when the survey is only asking where specific purchases are made; it is still possible that certain areas are estimated better than others.
One final limitation is that, as we’ve listed throughout this article, the CPI is a living and very changeable index. Although the CPI will look at census data for shifts in demographics, this data is only recorded every 10 years. The migration patterns may have been in place long before then. This means that some of the data may be subject to sampling error.
The final word on the Consumer Price Index (CPI).
When it comes to measurement tools like the Consumer Price Index, one of the best ways to look at it is, it may not be perfect, but it’s the best we’ve got. The CPI does our economy and our government a service by attempting to create an accurate barometer of inflation relative to the goods and services most commonly purchased by the vast majority of our citizens.
The CPI is based on a compilation of a representative population sample in key demographic areas as defined by the U.S. Census. These participants are asked questions regarding where they purchase items in broad categories (food and beverage, transportation, medical expenses, etc.). From this survey, the Bureau of Labor Statistics conducts in-store or phone calls with the locations to monitor and report price movements. The result is the CPI data which is published monthly.
The CPI is a weighted average of goods and services. That means certain items are deemed more important to purchasing habits. In that way, much like an index fund, price movement in those areas will have a greater effect on the CPI as a whole.
The CPI is considered to be one of the leading economic indicators of the health of our economy and is a generally excepted measurement of inflation. A wide swing in the CPI or incremental movement over the period of many months can be the catalyst for new fiscal or monetary policy by the U.S. Government. The CPI is also widely used as a baseline for determining cost-of-living adjustments for a wide section of our population most notably Social Security recipients who may rely on such increases to help them live on a fixed income.
Like all statistical measurements, the CPI has limitations. Most notably, it reflects the average behavior of the average household used in the survey. It would be nearly impossible for the report to accurately predict the individual impact of inflation on every household.