Consumer Price Index

ByNathan Paulus
Edited byAliha Strange

Updated: May 18, 2023

ByNathan Paulus
Edited byAliha Strange

Updated: May 18, 2023

What Is the Consumer Price Index?

The Consumer Price Index (CPI) reflects average price changes across goods and services paid by American consumers. It shows how the cost of living changes during a specific period of time.

The Bureau of Labor Statistics (BLS) tracks and calculates the CPI based on weighted average prices for a basket of goods and services. This basket includes products that consumers usually buy. Thus, reflecting day-to-day consumption.

Economists and policymakers use CPI to determine if thereâ€™s inflation. The Federal Reserve also uses the CPI to monitor economic growth and check if thereâ€™s a need to modify economic policies.

Understanding CPI

The CPI is a measurement of seasonal changes in prices based on a basket of goods and services. It reflects the amount urban consumers spend on certain products.

CPIâ€™s history can be traced back to World War I when government officials and labor chiefs founded the Shipbuilding Labor Adjustment Board to handle labor disputes. One of the main concerns is to come up with a fair wage scale. The Board created a cost-of-living index to record changes in commodity prices, mainly for wage negotiations.

There were revisions throughout the years regarding the life necessities and the weighting structure of goods and services. It was in 1964 when the third comprehensive revision was finalized. Changes include a new sample of metropolitan and urban areas, a new market basket and the inclusion of single workers living alone to make the index more representative of urban wage earners and clerical workers.

HOW TO INTERPRET INDEXES

Indexes measure numerical movements. Changes are expressed in index points, which can be measured by subtracting the past number from the current one. For instance, an itemâ€™s index is 110 for Year 1 and 115 for Year 2. The change in index point for that item is 5.

Another way to present numerical movements is through percent changes. Using the same example, the percent change for the given item is 4.55. It was calculated using the formula:

(Change in Index Points/Year 1) x 100 = (5/110) x 100

Types of Consumer Price Indexes

The BLS reports two types of CPI â€” the Consumer Price Index for All Urban Consumers (CPI-U) and the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

The CPI-U index includes expenditures of all consumer groups in urban and metropolitan areas, including urban wage earners, clerical workers, professionals, self-employed individuals, unemployed residents and those experiencing poverty. It represents approximately 93% of the U.S. population.

On the other hand, the CPI-W index includes only a subset of the population in the CPI-U. These are consumers whose household income is mainly from clerical or wage occupations. Additionally, at least one earner from the household must be working for at least 37 weeks during the previous year. The CPI-W index population represents only 29% of the U.S. population.

Economic Indicators of Inflation and Deflation

Generally, the CPI is an economic indicator. Policymakers and economists measure inflation or deflation by analyzing changes in the prices of goods and services. This is important as excessive inflation or deflation can lead to economic recessions.

The Federal Reserve uses CPI as a factor to determine when to adjust monetary policies chiefly through the Federal Funds Rate.

Other uses of CPI include:

• Adjusting other economic series: The CPI is used to adjust other economic indicators for price changes to make inflation-free indexes. Examples of economic series include retail sales, components of national income or hourly and weekly earnings.
• Adjusting payments: The CPI can affect the income of millions of individuals as many worker agreements tie wages to the index. It also greatly determines benefits and payments for Social Security and other government assistance programs.

The CPI reflects the price movement of specific products consumed in urban and metropolitan areas. It covers a particular basket of goods and services. CPI data includes items from hundreds of categories. The Bureau of Labor Statistics (BLS) sorts these goods and services into eight major groups, namely:

• Food and beverages
• Housing/shelter
• Apparel and commodities
• Transportation
• Medical care
• Energy
• Education
• Other goods and services purchased for day-to-day living

These major groups also include government fees and taxes associated with the prices of certain consumer goods or services.

In calculating CPI, the BLS uses weighted averages for each major category. Currently, housing holds the biggest share at 32.5%. Itâ€™s followed by apparel and commodities at 21.3%. Food and beverages received the third largest share at 13.6%. Meanwhile, education holds the least weight at 5.3%.

Weighted averages change now and then. The BLS updates them every two years.

CPI produces different types of data. CPI can be used to show the following:

• Indexes and percent changes
• Average food and energy prices
• Relative expenditure weight
• Relative importance data
• Base conversion factors
• Seasonal factors affecting unadjusted indexes

The BLS collects data in-person, via phone calls or the web. The Bureau calls doctorsâ€™ offices, rental units, retail stores and service establishments across the country to get price information on thousands of items to see how much consumers pay for certain goods and services. Approximately 80,000 items are monitored monthly.

Using data collected throughout the month, the BLS publishes the monthly CPI to report the estimated pricing for select items.

CPI Historical Data

Although the collection of family expenditure data only started in 1917, the earliest estimates found in the BLSâ€™ CPI historical data are from 1913.

In 1921, the regular and periodic publication of the index was established. Quarterly indexes were introduced in 1935. Monthly indexes began in 1940 upon the request of the National Defense Advisor Committee.

Comparing annual average CPI-U data shows how the cost of living has changed over time. In 1913, the yearly average CPI was only 9.9. The estimated average for 2022 is 294.4.

Although the rates of price increases over the years vary widely, with specific years showing slower growth, the CPI shows an upward trend overall. This is also reflected in the annual rate of inflation. A higher increase in the CPI yearly average leads to a higher inflation rate.

Calculating the Annual CPI

The BLS calculates price changes using the CPI formula, which considers costs from the current year and the base year. For annual changes, the base year is the previous year. The complete formula is as follows:

Before applying the CPI formula, the BLS gathers data by selecting urban areas based on the U.S. Census. The Consumer Expenditure Survey results help determine a sample by allowing the BLS to identify areas where households buy and consume various goods and services.

The CPI basket includes commonly purchased items by American consumers. The BLS assigns a weight for every component based on importance and how the items are sold.

Once the items and samples are finalized, the BLS tracks prices. To get the annual CPI, the BLS divides the current value of the basket by the value from a year ago and multiplies the result by 100.

Letâ€™s say weâ€™re in the year 2078 and a consumer wants to know the annual CPI to check how the cost of living has changed in a year. Hypothetically, goods and services would be more costly than in 2022.

In this example, the basket of goods and services in 2078 would be \$41,725. To find the CPI, the individual would have to check the BLSâ€™ historical data and look for the basketâ€™s value in the previous year (2077). If the basketâ€™s value in 2077 was \$40,659, the annual CPI for 2078 would be 102.62.

Year

2077 (Base/Previous Year)

\$40,659

2078 (Current Year)

\$41,725

You can use the above formula to calculate the CPI of any given year.

Limitations of the Consumer Price Index

The BLS uses the CPI to keep track of price changes. However, the index may not always reflect individual consumer experiences. Thatâ€™s because the CPI has limitations.

For instance, the index only gathers data from urban areas. Consumers living in rural areas arenâ€™t part of the sample population. Furthermore, the CPI data only reflects average changes in the cost of a representative basket of goods and services over a certain period. It may not have similar values to the actual prices of all retail purchases. That means the CPI isnâ€™t a perfect gauge of the countryâ€™s overall economy.

Its Methodology Has Changed Over the Years The methodology the BLS uses for the CPI has changed over the years. The index had a fixed basket of goods and services in the past. During that time, the CPI was mainly a cost of goods index. Over time, the focus shifted to the cost necessary to maintain a standard of living. Thus, the CPI turned into a cost-of-living index.

Further changes were adapted over the years. Currently, the CPI also considers substitution. Because of price changes, consumers may also change the items they purchase. To reflect these changes, the BLS may change the relative weighting of the basket of goods and services components.

Prices in Rural Areas Are Excluded

The CPI takes into consideration consumer expenditures in urban areas. Although the CPI-U, which has a broader scope, covers around 93% of the U.S. population, the index still needs to encompass many consumers. Thatâ€™s because the BLS doesnâ€™t track the buying habits of households in rural or more suburban areas.

In this sense, the CPI simply reports consumer spending made by urban consumers. It doesnâ€™t reflect consumption in rural places where prices may be different.

Sampling Errors

The CPI isnâ€™t a perfect tool. Since it reports statistical estimates, sampling errors are possible. There may be slight differences from actual records of retail purchases by consumers. The index also focuses on a representative market basket, which only includes certain goods and services commonly purchased by the sample population. That means it doesnâ€™t reflect prices for all types of products.

Bias and Substitution Bias

One of the criticisms to CPI is the possibility of having bias, which may influence the precision of data. In this case, bias is the difference between an item's expected value and true value.

Bias can lead to overstating or understating CPI, which can also be translated to overstating or understating inflation rates.

Another issue raised is substitution bias. Itâ€™s when consumersâ€™ purchasing behavior changes because of price changes. In the past, the CPI didnâ€™t consider substitution when evaluating CPI. Although the CPI currently considers substitution, itâ€™s limited to substitution across brands or types. It doesnâ€™t consider substitution across categories.

Hidden Inflation

The CPI helps determine and measure inflation. However, it fails to cover hidden inflation or the expenses not shown in price changes.

One form of hidden inflation is shrinkflation. This is when businesses reduce the size or quantity of their product and offer it for the same price. For example, if a customer purchases a bag of chips, it will likely cost the same, but the bag will contain fewer chips.

Other forms of hidden inflation may be seen in terms of quality. For instance, companies may cut corners on assembly lines. Consumers end up spending the same amount for less durable products.

Consumer Price Index FAQ

What is the Consumer Price Index (CPI) in economics?
What basket of goods is used to construct the CPI?
What is CPI inflation?
What are the three reasons why the CPI is hard to measure accurately?
How is CPI used?

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