What Is the Consumer Price Index (CPI)?

An important economic indicator, the CPI provides valuable insight into the changes in the household cost of living. It assesses the overall economic health of the country and the impact of inflation on consumer spending.

The CPI measures changes in the average prices of goods and services, from housing and food to medical care and transportation. The Bureau of Labor Statistics (BLS) updates the CPI monthly after recording the price of approximately 80,000 items. Like a stock market index fund, 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 two primary versions of the CPI: 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 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, self-employed and unemployed, and retirees. 

The monthly CPI reports are broken 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 for 13 additional metro areas. This data reflects the habits and spending of the average consumer. It collects information on the prices of various items, including food, housing, energy, transportation, medical care, apparel and more.

Because the CPI tracks how the cost of a fixed basket of goods changes over time, it serves as a proxy for inflation. However, it is not synonymous with inflation itself. While the CPI calculates the average price levels, inflation refers to the rate of price increases. When the CPI rises, it signals that the purchasing power of money is declining as goods and services become more expensive.

The CPI encompasses multiple categories, each reflecting a significant aspect of consumer spending:

• Housing: Rent, owner's equivalent rent, utilities, and home maintenance.
• Food and Beverages: Groceries (food at home) and dining out (food away from home), plus alcoholic beverages.
• Transportation: Vehicle purchases, fuel, maintenance, public transit, and airfare.
• Energy: Electricity, gas, heating oil, and other fuels (sometimes considered part of housing or transportation costs).
• Medical Care: Doctor visits, hospital services, prescriptions, and health insurance.
• Education and Communication: Tuition, textbooks, internet services, and telecommunication costs.
• Apparel: Clothing, footwear, and accessories.
• Recreation: Sporting goods, hobbies, pets, and admission to entertainment venues.
• Other Goods and Services: Personal care products, water and sewer services, trash collection, and miscellaneous personal expenses.

Items included in the CPI are selected based on their relevance to the spending habits of a diverse group of consumers. Here's an overview of the process:

• Consumer Expenditure Surveys: The BLS conducts surveys to identify the goods and services households purchase regularly.
• Market Basket Development: A "market basket" of goods and services is created based on survey results, reflecting the spending patterns of the average urban consumer.
• Item Categorization: Items are grouped into categories such as food, housing, transportation, medical care, and recreation.
• Weight Assignments: Each item or category is assigned a weight based on its relative importance or share in total consumer spending.
• Periodic Updates: The market basket is updated every few years to account for changes in consumer preferences and new goods or services entering the market.
• Geographical Sampling: The BLS ensures a representative sample by selecting items and prices from various regions, reflecting diverse urban consumer spending.
• Outlet Selection: Prices are collected from various retail outlets, including physical stores, e-commerce platforms, and service providers, to ensure comprehensive coverage.

This method ensures the CPI accurately reflects the cost of living and inflation trends over time.

The CPI calculation involves:

1. Collecting Prices: BLS surveys prices at retail locations, online stores, and service providers.
2. Weighting Items: Items are weighted based on their importance in consumer spending patterns.
3. Comparing Periods: The average price of the basket is compared to a base period (e.g., 1982-1984).

For example:

• July 2013 CPI: 233.596
• July 2012 CPI: 229.104
• Change = (233.596 - 229.104) ÷ 229.104 = 1.9% inflation rate

The CPI is a key economic indicator used to measure the cost of living and guide policy decisions. Its applications include:

• Social Security Adjustments: Annual cost-of-living adjustments (COLAs) for millions rely on CPI data.
• Tax Brackets: Prevents "bracket creep" by adjusting income thresholds for inflation.
• Business Decisions: Guides pricing strategies and wage negotiations.

For consumers, the CPI offers insights into purchasing power and how inflation impacts household budgets.

While widely regarded as a robust measure of inflation, the CPI has notable limitations:

1. Exclusion of Certain Groups: Omits rural populations, active military, and institutionalized individuals.
2. Substitution Effect: Doesn’t account for consumers switching to cheaper alternatives (e.g., swapping beef for chicken).
3. Quality Adjustments: Ignores product quality improvements, such as tech upgrades in smartphones.
4. Online Shopping: Underrepresents e-commerce pricing, despite its growing share of consumer spending.
5. Sampling Errors: Based on averages that may not reflect individual household experiences.

For instance, rising healthcare costs may heavily affect one household, while another household may offset those costs through energy savings from solar panels.

The CPI significantly influences financial markets. Rising CPI often foreshadows higher interest rates, which can dampen stock prices by increasing borrowing costs and reducing profit margins. Investors monitor CPI data closely to adjust portfolios based on potential macroeconomic shifts.