As consumers, we know when the price of the items we regularly consume increases. 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 results from geopolitical events like storms or military conflicts and when they are a 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 the Consumer Price Index, it would be helpful 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 listed on either the New York Stock Exchange (NYSE) or the NASDAQ.
Like many 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.
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.
The data reflect 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.
The data published by the CPI includes the average prices of specific items over a given period, as well as the change in the price of those items compared to the previous period. It also provides information on the impact of inflation on the cost of living by calculating the cost of a fixed basket of goods and services.
The CPI is an important economic indicator, providing 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 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.
Does CPI Measure Inflation?
Yes! But how does CPI measure inflation? CPI tracks the changes in prices of goods and services over time. Individuals use CPI to compare the purchasing power of a currency between periods of time.
Is CPI the Same as Inflation?
No. Regarding CPI vs inflation, the CPI stands for the Consumer Price Index, which measures the average price of goods and services. Inflation measures the rate of price increases over a certain period.
What Happens When CPI Increases?
What does a high CPI mean? When CPI increases, it indicates that the cost of goods and services has increased, and the purchasing power of currency has decreased. In other words, the same amount of money buys fewer goods and services than before.
CPI Categories
The major categories in the Consumer Price Index include housing, food and beverages, transportation, energy and more. Let's take a closer look below.
Housing
The housing category measures the change in costs of goods and services related to housing, such as rent, property taxes, insurance, repairs and maintenance and fuels and utilities. It also measures the costs of purchasing new and existing homes, such as mortgage payments and real estate taxes.
Food and Beverages
The food and beverage category in the Consumer Price Index measures the changes in the price of food and beverages. It includes the price of food and beverages purchased for at-home consumption and those bought from restaurants, cafes and fast-food outlets. Some companies, such as those serving gourmet coffee, are considered consumer discretionary stocks. Read more about consumer discretionary opportunities.
Transportation
The transportation category measures the price changes of goods and services related to transportation, including public transportation fares, motor vehicle maintenance and repair costs, insurance and fuel costs.
Energy
The energy category of the Consumer Price Index measures the change in prices of energy goods and services, such as electricity, natural gas, fuel oil, motor fuel and other energy sources. This category is essential because energy costs significantly impact the cost of living and the overall economy.
Medical
The medical care category in the CPI measures the cost of medical services, goods and insurance, including doctor visits, hospital services, prescription drugs and health insurance premiums. Medical products are essential to human health and are therefore considered staples. Read more about the difference between consumer staples vs. consumer discretionary stocks.
Education and Communication
The education and communication category measures the changes in the prices of goods and services related to education and communication. For example, it includes tuition fees, textbooks, school supplies, postage stamps, telephone and internet services.
Transportation Services
The transportation category measures the price change of goods and services related to transportation. The category includes public and private transportation costs such as buses, trains, taxis and airline tickets. It also considers purchasing vehicles, such as automobiles, motorcycles and maintenance and repair services.
Household Furnishings and Supplies
The household furnishings and supplies category measures the average change over time in the prices consumers pay for a range of products used in the home. This category includes items such as furniture, major appliances, small appliances, kitchenware and items used in the maintenance and repair of the home. You can track many companies producing high-end furnishings through consumer discretionary ETFs.
Recreation Services
The recreation services and supplies category measures changes in prices of recreational goods, including sporting equipment, toys, recreational vehicles and recreational services such as admission to amusement parks and golf courses. It also includes recreational supplies such as fuel for recreational vehicles, fishing and hunting equipment and camping supplies.
Apparel
The apparel category measures the average change in clothing and footwear prices over time. The category includes the prices of items such as shirts, pants, dresses, shoes and other clothing items.
Other Goods
The "other goods" category includes:
- Recreation commodities
- Water and sewer
- Trash collection services
- Education and communication commodities
- Household operations products
- Alcoholic beverages
- Medical care commodities
- Other personal services
How Are Items Chosen for the CPI?
The CPI products 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. This survey aims to determine what locations families in the target areas purchase various items. This then forms the basis for how the BPI visits outlets to track price changes. A specific item is then chosen based on the probability that an item will be purchased based on how much that item contributes to that store's revenue in that category.
The CPI is revised whenever there is 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 consumers. In other words, they are deemed more critical 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 included in the CPI. The price changes are weighted based on the item's importance relative to the spending patterns of the specific population group. The weighted prices are added 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 essential to understand what the number is based upon.
According to the BLS "Handbook of Methods," the base period used for the CPI is between 1982 and 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%.
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.
The Bureau of Labor Statistics (BLS) collects data from various sources to calculate the CPI. The BLS surveys businesses and households about purchases and gathers price information from retailers and manufacturers. The BLS then combines this data to calculate the average price of the basket of goods and services.
The BLS takes the average price of the basket of goods and services and compares it to the average price of the same basket during a base period, usually the previous year. This comparison then calculates the CPI.
The CPI is calculated by taking the ratio of the current basket of goods and services to the base year basket of goods and services. The ratio is multiplied by 100 to determine the percentage change in the basket's price since the base year.
For example, if the current basket of goods and services costs $100 and the base year basket costs $90, the CPI would be 111.11. The basket's price has increased by 11.11% since the base year.
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 services is offset by the loss of purchasing power in a currency. The U.S. Government generally considers healthy inflation to be between 2% to 3%. When it starts rising above this, it may mean fiscal or monetary policy changes may be needed.
In the same way, businesses use the CPI to guide their pricing decisions, and consumers use the CPI to keep their household budgets in line. The CPI is not the only measure of inflation. Still, 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 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. Regarding metrics such as retail sales, the price changes in the CPI help translate these numbers into inflation-free dollars. The CPI also shows how the consumer’s purchasing power is declining because of a deflation in the dollar's value. As prices increase, the dollar's purchasing power becomes less, proving that a dollar doesn’t buy what it used to.
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 specific 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 cost-of-living adjustment (COLA) 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 and children eligible for free school lunches. Even some collective bargaining agreements use CPI data to determine wage increases.
How is the CPI Used?
Governments, businesses and individuals use the CPI to measure the cost of living changes. The government uses the CPI to adjust income tax brackets and other parameters to adjust Social Security payments and other government transfer payments and to adjust the prices of goods and services in government and private contracts.
Private businesses use the CPI to adjust wages and benefits for their employees, to adjust the prices of goods and services in contracts and to help make decisions about investments and other economic activities. Individuals use the CPI to help make investments, taxes, and other financial decisions. Read on for the answer to "How does the consumer price index affect the stock market?"
Is the CPI the Best Measure of Inflation?
The CPI is a useful measure of inflation, considering changes in the prices of many different goods and services. It is based on a fixed basket of goods and services representing what the average consumer buys. The CPI adjusts to account for changes in the composition of the basket of goods and services, including introducing new goods and services.
The CPI is not perfect, however. It does not consider the impact of changes in taxes, subsidies, or import prices, which can significantly impact the cost of living. It also does not account for the impact of quality changes, such as when newer versions of products come out. Additionally, the CPI does not measure changes in the cost of living for certain groups of people, such as those on fixed incomes or in rural areas.
Limitations of CPI
There are some downsides of CPI, including:
- Quality changes: The CPI does not account for quality changes in products. For example, a new laptop may cost more than the old laptop but may have longer battery life and more features.
- New products: The CPI does not consider new products that may have been introduced since the last survey.
- Substitution: The CPI does not consider that consumers may substitute one product for another due to price changes. For example, if the price of beef increases, consumers may switch to chicken.
Anytime you deal with averages, you will 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 similarly. Let's look at a couple of examples. Health care and medical expenses are items generally increasing in price every year. Suppose you are a healthy, single individual with no dependents. In that case, your overall inflation rate 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, suppose a family with high medical expenses also heats their home with solar energy.
In that case, 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 is how 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 turn 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.
Understanding the CPI
The Consumer Price Index is often used as a proxy of inflation and is therefore watched closely by stock market participants. When the CPI rises steeply, it often foreshadows higher interest rates, which can put downward pressure on stock prices. Therefore, investors must keep up to date with movements in the CPI to ensure their portfolios are positioned appropriately to changes in the macro environment.
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 government service by attempting to create an accurate barometer of inflation relative to the goods and services most commonly purchased by most 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 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. Like an index fund, price movement in those areas will have a greater effect on the overall CPI.
The CPI is considered one of the leading economic indicators of the health of our economy and is a generally accepted measurement of inflation. A wide swing in the CPI or incremental movement over many months can catalyze 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. These most notably Social Security recipients 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 predict the individual impact of inflation on every household accurately.
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