Consumer Price Index (CPI)

As stated in the previous article, the inflation rate, the rate at which prices of goods and services change, is determined by the economy's need for money and by the money supply. While it is not too difficult to measure the money supply, it is much more difficult to determine the economy's need for money, so knowing the inflation rate helps gauge whether the money supply is sufficient to satisfy that need and helps monitor the effectiveness of monetary policy in promoting maximal economic growth. The CPI is not only used to determine the effectiveness of monetary and fiscal policies, but also sets the level of payments for recipients of Social Security and other social entitlements.

The inflation rate is determined by the general price increases of consumer goods and services over time, which is measured by price indexes which reduce the prices that consumers spend in 1 year to a simple number that can be easily compared to other years. Several price indexes are calculated by the Bureau of Labor Statistics (BLS), but the most popular measure of inflation as reported in the press is the All Items Consumer Price Index for All Urban Consumers (CPI-U) for the U.S. City Average, 1982-84 = 100, usually just called the Consumer Price Index (CPI).

Another closely related inflation measure, called the Personal Consumption Expenditures (PCE) index, accounts for changes in consumer spending sooner, when prices of some items rise faster than substitutable items. For instance, if beef prices rise faster than chicken prices, then people will buy more chicken. So, the PCE index will always be lower than the CPI. Because the PCE index is considered more accurate, the Federal Reserve relies on the PCE index when setting monetary policy.

The government started using the CPI in 1921. The CPI now incorporates the prices of more than 80,000 goods and services. However, a criticism of the CPI is that it includes items that many people do not buy, such as sports tickets, air travel, second homes, and golf carts. The CPI also measures some costs that most people do not pay directly, such as the cost of medical care that is mostly paid by insurance companies. To measure housing costs, the CPI uses owners' equivalent rent, what homeowners think their dwelling would rent for, rather than using actual market rents.

However, medical costs in the form of insurance premiums, deductibles, out-of-pocket costs and market rents, the costs that most people actually pay, have risen faster than the CPI. Thus, the CPI does not accurately measure inflation as experienced by many people, especially lower-income people.

Some new inflation indicators have been developed to better measure inflation as experienced by most people, such as the True Living Cost index, which measures inflation of most households’ minimal needs, such as housing, transportation, groceries, childcare, and other frequent expenses, such as clothing, personal technology, and Internet services. Even the Federal Reserve uses the PCE price index, which is considered a more accurate measure of inflation, since the prices are measured on items that people are buying, thus more quickly measuring changing behavior that results when prices rise or drop for different items.

Nonetheless, the CPI does give some indication of the inflation rate in general.

The CPI attempts to measure the relative difference that consumers currently spend on goods and services, called the consumer market basket, compared to some base year. Hence, to calculate the CPI requires that information be gathered to determine what consumers are actually buying and in what proportion to their total expenditures, and the prices of the goods and services being bought.

For instance, suppose that the BLS determines that in the base year, consumers spend 25% of their income on food, 50% of their income on housing, and 25% for everything else. Then let's say that they found that consumers paid these averages for the year:

• food, $8,000,
• housing cost $20,000,
• everything else, $16,000.

Then the index would be calculated thus:

Base CPI

• = .25 × 8,000 + .5 × 20,000 + .25 × 16,000
• = 2,000 + 10,000 + 4,000 = 16,000, which is normalized to a base of 100.

Note that the 16,000 is just a number — it's not dollars nor is it what a typical consumer actually pays. It is just an index number used as a base to determine the inflation rate in subsequent years. So 16,000 is set to the CPI base equaling 100. In subsequent years, the base number of 100 will be increased by the same amount as the increase in general prices.

So let's say that 5 years hence, prices increased and the proportion of each category changed slightly, yielding this calculation:

Current CPI

• = .20 × 10,000 + .45 × 22,000 + .35 × 20,000
• = 2,000 + 9,900 + 7,000
• = 18,900

This formula will yield the CPI increase over the 5-year period:

CPI Increase = 18,900 / 16,000 = 1.1813 = 118.13%

To calculate the new CPI number, the CPI base of 100 is multiplied by the CPI increase:

New CPI Number = 100 × 1.1813 = 118.13

The inflation rate can be calculated thus:

Inflation Rate

• = (18,900 − 16,000) / 16,000 × 100
• = 2,900 / 16,000 × 100
• = 0.1813 × 100
• = 18.13%

or, using the price index for each year:

Inflation Rate

• = (118.13 − 100) / 100 × 100
• = 118.13 − 100
• = 18.13%

As of May 2021, the Consumer Price Index for All Urban Consumers (CPI-U) reached an index level of 269.195 (1982-84=100). So the inflation rate since 1984 can be calculated thus:

Inflation Rate = 269.195 / 100 = 2.69195 = 269.195%

As you can see, setting the base CPI at 100 greatly simplifies calculations. Most specific CPI indexes have a 1982-84 reference base. That is, BLS sets the average index level (representing the average price level) for the 36-month period covering the years 1982, 1983, and 1984-equal to 100.

Since the consumer market basket depends on what consumers purchase, the BLS gathers detailed expenditure information from families and individuals on what they actually bought. This is done every 2 years to correct substitution bias, which results when people substitute products and services for lower cost replacements or even foregoing a more expensive item or service. Substitution occurs because different products and services have different rates of inflation, and, thus, over time, some products and services become more expensive relative to other consumer items.

To determine prices, each month, BLS data collectors called economic assistants visit or call thousands of retail stores, service establishments, rental units, and doctors' offices, all over the United States, to get information on the prices of the thousands of items used to track and measure price changes in the CPI. These economic assistants record the prices of about 80,000 items each month, representing a scientifically selected sample of the prices paid by consumers for goods and services purchased.

Hence, the CPI measures inflation as experienced by consumers in their day-to-day living expenses.

The products and services of the CPI consumer basket are classified into more than 200 categories, arranged into 8 major groups (with examples of each category):

1. food and beverages — including full service meals
2. housing — including owners' equivalent rent, bedroom furniture, and fuel oil
3. apparel — including jewelry
4. transportation — including the cost of new vehicles, motor vehicle insurance, public transportation fares, gasoline
5. medical care — including prescription drugs and medical supplies, and medical care services
6. recreation — including consumer electronics, sports equipment, toys, pets and pet products, entertainment admissions
7. education and communication — including education tuition, postage, telephone services, computer software and accessories
8. other goods and services — including tobacco and smoking products; personal services, such as those provided by barbershops, beauty salons, and health clubs; and funeral expenses

Taxes that increase the cost of consumer goods or services are included, such as sales and excise taxes. However, income taxes are not included since they do not affect the cost of the consumer basket.

Shortfalls of the Consumer Price Index

Because the CPI is based on the urban consumer, the CPI may not accurately represent the consumer market basket of rural consumers. Additionally, the CPI may not represent purchases by subgroups, such as the elderly. As noted above, there is a lag in adjusting the basket of goods and services due to substitution effects. Also, the CPI only measures price changes over time for a given area; it does not measure the differences in prices across geographic areas.

Although the CPI tries to account for quality improvements, these are subjective and difficult to quantify, and incorporating quality improvements takes time. These quality adjustments do not reflect all quality differences. Likewise, for the introduction of new products and services.

And because the CPI is based on statistics, it is naturally subject to all the errors that arise in gathering statistics, including sampling errors and the many problems of collecting data.