The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Indexes are available for the U.S. and various geographic areas. Average price data for select utility, automotive fuel, and food items are also available. (U.S. Bureau of Labor Statistics https://www.bls.gov/cpi/ )
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CPI-U starting from 1913; Source: U.S. Department Of Labor
CPI vs M2 money supply increases
The United States Consumer Price Index (CPI) is a set of consumer price indices calculated by the U.S. Bureau of Labor Statistics (BLS). To be precise, the BLS routinely computes many different CPIs that are used for different purposes. Each is a time series measure of the price of consumer goods and services. The BLS publishes the CPI monthly.
Guide to Consumer Price Index
Investors are bound to encounter many terms. One of them is the consumer price index (CPI), which represents essential numbers. The CPI can reveal the health of the economy, helping investors determine whether or not inflation is possible.
This guide will help you understand what CPI is, its importance, and the current index. You will also learn how to calculate CPI.
What Exactly is the Consumer Price Index?
The Consumer Price Index (CPI) provides the measurement of the average change in prices of specific goods and services. Transportation, food, clothing, energy, and health care are among those that CPI measures.
Often, CPI is for measuring inflation, which allows the government, companies, and economists to understand the cost of living at a particular period.
In short, the CPI is an economic indicator. Along with its components, the CPI can be used to deflate other economic factors. It is why this percentage is vital to the government, businesses, and many other citizens.
As a deflator, the consumer price index helps control retail sales, consumer dollar value (for determining the purchasing power), and hourly or weekly earnings. Therefore, monetary value declines whenever the prices increase.
Why is the CPI Important?
In the economy, money flows in a circle, while other factors are considered, including production, goods, and services.
Let us dive in deeper.
As a worker, you earn an income that allows you to buy goods and services. This year, you spent it on different products. When you go to a store, you take some money with you to purchase things you need for some time, such as eggs, milk, orange juice, and cereal.
You also buy gas for your car, and you pay utility bills. All these expenses, including your plane fare to another country, doctor fees after a checkup, and buying a new car, will be incorporated into the yearly CPI. They will be measured across the whole financial system.
The question is: why does it matter?
When you go to the store next year, the same amount you spent last year may not have the same buying capacity. Prices of goods and services change over time – usually in an upward trend. During this time, your cost of living may have already increased. From the products you buy at the store to filling up your gas tank to your utility bills, your expenses may be higher than last year’s.
The CPI gives significant numbers to identify periods of inflation (or even deflation). Mainly though, the consumer price index is for measuring inflation, determining the cost of living, and understanding the efficiency of economic policies.
Tracking inflation is crucial because it is an indication of a healthy (or unhealthy) economy. It will be much easier to respond to inflation appropriately, which is significant to policymakers.
There are times when inflation would sharply increase. Knowing the CPI enables economists to gain an insight into the economic policy of the government that could affect the market. Therefore, it becomes easier to identify whether or not the present strategies work correctly. If not, the government can use it to create better policies in the coming years.
Inflation, when not appropriately determined, can have a considerable effect on the economy. It can make the cost of living difficult to maintain, especially if work salaries cannot keep up with the increasing prices of goods and services.
Ultimately, inflation lowers consumers’ living standards, which could mean a lower quality of life. It gets worse when inflation turns into hyperinflation, which causes financial devastation for the whole country’s economy.
With CPI, inflation and cost of living can be monitored. This way, the situation can be controlled before it gets out of hand.
All in all, the consumer price index is one way to help maintain a healthy and robust economy.
The CPI is also used to realign the eligibility levels of individuals for different types of assistance from the government. It includes Social Security, which automatically adjusts wages based on wage adjustments. The Bureau of Labor Statistics (BLS) has stated that the cost-of-living adjustments (COLA) of over 50 million Social Security users are based on the CPI. Others include retirees from the Federal Civil Services and the military as well.
Why Should You Care?
Aside from the reasons given above, the CPI statistics involve almost every individual in the country. Whether you are self-employed, working in a corporation, unemployed, retired, or have low income the CPI reports includes you. Those who are not in the report are from farm families, rural areas, inmates, and the patients in mental hospitals.
What is the Current CPI?
The US Bureau of Labor Statistics (BLS) calculates different consumer price indices for a variety of purposes.
Here is the CPI formula:
-The cost of the market basket in a specific period divided by the base year cost of the market basket
-Multiply the answer by 100
Let us break down the elements of the CPI formula.
As you can see from above, the formula requires the “market basket” of goods and services. Then, it uses the estimated costs of a basket to get the index value (known as the CPI).
The market basket is deemed imperfect; however, it attempts to provide quality representation of consumer purchases from different categories, including:
- Medical care
- Food and beverage
- Health and medical care
The complete list of all the types and measurements performed is on the BLS website.
The inclusions of the basket are determined by collecting information from individuals over two years. Purchase details are gathered, which involve regular expenses and behavior in the consumption of goods.
According to the BLS, data from 2016 and 2017 came from the 2013 and 2014 Consumer Expenditure Surveys. About 24,000 people provided information about their quarterly spending habits. About 12,000 more consumers were included in the survey to make sure data was nearly accurate. They were asked to keep a list of everything they have bought for two weeks.
For two years, the collected information came from 48,000 people whose quarterly expenditures were recorded and another 24,000 with their biweekly diaries. The details helped determine the weight of the items based on the CPI structure.
Using all the gathered information, the market basket was built where both the items and their numbers were recorded. For instance, specific consumer purchases three gallons of milk regularly each month. The product and the quantity are both logged. They are just among the data analyzed to determine the weight or importance of items based on customer behavior.
It should be noted that purchase behavior does not include rural customers. Therefore, they are not considered when getting the consumer price index. Still, the total number of urban consumers amount to approximately 93% of the population in the US.
How is the Market Basked Priced?
The CPI formula can get a bit complicated when you do not know what the market basket price is. The first step is to figure out which products and services are included in the market basket. After that, logging the prices for the basket comes next. In this case, it included both the previous and current costs of different goods and services.
Knowing the current price of the basket, along with its history, gives analysts the ability to see the changes of the identified basket – whether the goods have increased or decreased over time.
BLS data collectors are tasked to collect detailed information regarding the prices of goods and services. Most of the work involves visiting thousands of companies, health centers, stores, and online shops as well. BLS has confirmed that the recorded prices of market baskets reach 80,000+ items monthly.
What about the Base Year?
Aside from the market basket, the base year should also be identified to compute the consumer price index. The base year is used as a benchmark year to compare it with the future years. Therefore, it can change anytime. Even so, it does take some time for it to adapt to obtain better data for comparison.
As seen in the CPI formula above, the market basket price of a particular year, such as the current year, will be divided by the base year’s worth of the same market basket. The quotient will be multiplied by 100 to get the CPI.
It should be noted though that the base year’s CPI will remain 100 since the formula asks to divide the market basket price by itself. Therefore, the result is 1. Multiplying the value by 100 allows us to see whether there is an increase or decrease in the consumer price index.
Meanwhile, if year three’s CPI is 125, for example, you can quickly compare the CPIs and see there is a 25% increase.
Understanding and using the consumer price index also involves knowing how to interpret the index value itself. As you may have learned, indices help streamline the movements of a data series. The difference between the index values can be read as “points,” but describing it in percentage makes it easier to understand.
Types of Consumer Price Index
Every time the BLS creates the CPI report, it comes with two types of CPIs. The first one is known as CPI-W, which measures urban wage and clerical workers. From 1913 to 1977, the BLS only estimated this type of CPI in which households with administrative or wage jobs participated based on their income. The statistics also focused on families with at least one worker who had been employed for 37 weeks or more for a particular year.
The primary reflection of the records showed the changes in the benefits offered to those individuals in Social Security. Today, this CPI represents 28% (at the very least) of the country’s population.
The other type of consumer price index is CPI-U, which is for urban consumers. This measurement now accounts for almost 90% of the US population. Therefore, it is more accurate since it represents the more significant portion of the general public.
In 1978, improvements were made to the methods of measuring the CPI. A broader group of people was introduced. CPI-U was based on how people in metropolitan or urban areas spend their money. The group includes professionals, retirees, and even the unemployed. Urban wage and clerical employees were also in the statistics.
Even with the existence of CPI-U, the BLS still measures CPI-W. However, the main difference between these two types revolves around the expenditure weights of item categories and where the consumers are located.
The consumer price index has cemented its importance in analyzing the economy for investors, the government, economists, and many others. However, some people seem to think of CPI as inaccurate, especially when it comes to determining inflation. Some would argue that it overstates inflation by about one percent. This argument stems from the perceived bias toward expensive products and services.
In a way, it does have some limitations. The rationale behind the “bias” involves a few points. First, the consumer price index should not be used when considering the substitution effect. It happens when the prices of certain goods or services increase. When there is an increase, the natural reaction of consumers is to go for the more affordable product of the same value, quality, or category. However, the CPI fails to take into account such a change.
Instead, CPI assumes consumers will continue purchasing the same products or basket. The only time it will be modified is when the behavior or buying patterns of the consumers will change toward a particular item when new data pulling occurs.
Another limitation takes place when different products increase in quality. Such a change is difficult to quantify, which means CPI cannot be measured. Consumers do benefit from better quality, but this change cannot be tracked until new data show a new pattern in buying.
It should be noted that the CPI also includes taxes from sales, but does not comprise of income taxes, as well as prices of stocks, bonds, and other investments.
The CPI also does not include the sales price of houses in the country, which can also change drastically from time to time. However, the index value does include the monthly equivalent of being a homeowner, which depends on rent prices.
At this point, it can be misleading since rental rates can drop whenever vacancy rates are high. This phenomenon typically happens when the interest rates are low, while prices of homes for sale are on the rise. The conclusion is that people tend to purchase houses when they see a thriving market.
On the other hand, home prices become cheaper when interest rates increase. As a result of the housing market’s deterioration, people tend to move to rental homes, such as apartments. The move only causes rent prices to increase.
Due to how CPI is measured, the result can give a deceptively low reading during those times when rents are cheap, and home prices are high. It was one of the reasons why the consumer price index did not notify authorities and some experts about the 2005 housing bubble.
Some, including the school of economics in Austria, would argue that the consumer price index should not be prioritized. The value may not mean that much, as well as the impact of inflation. While inflation is often viewed as the effect of rising prices, Austrians, especially those at Mises.org, believe otherwise.
Economists and other professionals of the Austrian School consider inflation as a decline in the value of capital relating to the products and services it can buy. Furthermore, inflation is a phenomenon involving money, not the price. According to the institution, the prices do go up. However, the increase takes place because inflation is occurring and not the other way around.
Nevertheless, setting aside any other interpretations, it is undeniable that CPI is valuable. It is why the government and its agencies, along with economists in the country strive to grasp it.
The simple fact is this: the consumer price index is widely utilized all over the country. Whether or not you agree with it and its value, the formula itself is unquestionable. CPI can assist in measuring inflation, even though it is not the only value that should be considered.
Inflation has always been one of the biggest dangers to a thriving and stable economy. When it occurs, people’s standard of living is greatly affected. The only way to survive it is to make sure your income does not go down as the prices rise. As it continues, inflation causes the cost of living to increase.
A high enough inflation rate can devastate the US economy. For the Federal Reserve, the CPI helps in determining economic policies that should be changed to avoid inflation. Contractionary monetary policy is often used to slow down the country’s economic growth right before inflation starts.
Currently, the consumer price index does not show any threats of inflation. It is good news for both the country and the consumers. The BLS will continue to update or revise the CPI when needed, particularly when consumer buying habits shift significantly.