CPI or “consumer price index” is a weighted average of the prices paid by urban consumers for a market basket of typical consumer goods and services. In the U.S., the data used to measure CPI is collected and maintained by the Bureau of Labor Statistics (BLS).
The significance of CPI is that it can be used year over year or even month over month to determine the rate of price changes for a geographical region. When the change in CPI is positive, the economy is in a state of inflation. When the change in CPI is negative, the economy is in a state of deflation. Every month, the BLS releases its latest CPI and inflation report providing insight into a variety of different sectors.
Types of CPI
When talking about CPI, it’s important to recognize that the BLS computes several variations of CPI. Below are a few of the most commonly used ones:
- Consumer Price Index for All Urban Consumers (CPI-U) – This is the figure most people will hear reported on the news. CPI-U represents families living in urban areas and has been estimated to cover 87 percent of the total U.S. population.
- Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) – This variation of CPI is used to represent families living in urban areas where more than one-half of the household income comes from clerical or hourly-wage occupations. CPI-W is often used for major government programs such as Social Security cost of living adjustments (COLA).
- Core Consumer Price Index (Core CPI) - This is the same as CPI; however, it excludes food and energy. The prices in these two sectors are more volatile and susceptible to fluctuations. Therefore, by removing them, the BLS gets a more accurate representation of the broader economy.
How is CPI Calculated?
CPI is calculated by taking the current weighted value of a specific basket of goods and services, dividing it by a previous measurement (generally the prior month or year), and then multiplying it by 100. For example:
CPI = [current price / previous price] x 100 = [ $105 / $100 ] x 100 = 105
In a similar way, the rate of inflation can be calculated by comparing the CPI from two different time periods:
Inflation = [[CPI current – CPI previous] / CPI previous] x 100 = [[ 105 – 100 ] / 100 ] x 100 = 5%
What Items Does CPI Consider?
The BLS considers dozens of different items and their subcategories when estimating changes in price. Each is given a weight or “relative importance” when the CPI calculation is being performed. As of December 2022, the top major groups for CPI-U include:
- Shelter 34.41%
- Food 13.53%
- Energy (fuel, utilities) 6.92%
- Medical care services 6.65%
- Transportation services (insurance, airfare, etc.) 5.75%
How is CPI Data Collected?
The BLS collects its price data by surveying 75 different urban areas throughout the U.S. and from approximately 23,000 retail and service establishments. Rent prices come from roughly 50,000 landlords and tenants.
The BLS solicits this information through the Consumer Expenditure Survey (CE). CE’s can either be an:
- Interview Survey for major and/or recurring items
- Diary Survey for more minor or frequently purchased items
CPI and Monetary Policy
Since CPI is one of the most widely used ways to track inflation, its changes are analyzed and discussed regularly by economists. This became especially prominent in 2022 when the year-over-year CPI peaked at 9.1% in June. Until this point, the U.S. economy had not had an inflation increase of this magnitude in nearly 40 years. When this happens, it’s the job of the U.S. central bank, the Federal Reserve, to stabilize the economy and bring inflation back under control.
The Fed’s target is to keep annual inflation to a modest 2% increase. To do this, their main tool is to raise the federal funds rate – the interest rate that banks charge to lend money to one another overnight. When the cost of borrowing goes up, spending decreases which should reduce demand and bring down consumer prices. Alternatively, as the economy stabilizes, the Fed can lower interest rates which bolsters demand again.
Personal Consumption Expenditures
Although most people reference the change in CPI when talking about inflation, the Federal Reserve chooses to use a different index: the Personal Consumption Expenditures (PCE) price index.
Although the PCE is produced by the Bureau of Economic Analysis (BEA), it has many similarities to the CPI. For instance, it includes many of the same categories and even uses the same data collected by the BLS. The main difference is that the PCE takes into consideration the change in prices for all consumption items, not just those paid by consumers. For example, PCE would also take into consideration costs covered by employer-provided insurance, Medicare, and Medicaid.
Also, the Fed uses core PCE. Similar to Core CPI, core PCE removes food and energy from the calculation.
How CPI Affects Consumers
There are several reasons why it's important to measure CPI and track the rate of inflation. The following are some of the ways it affects everyday consumers.
- Purchasing power – Inflation can often be described as the erosion of one’s ability to purchase the same goods or services over time. Since wages tend to increase slowly, it’s important for consumers to know that their income will enable them to cover their living expenses, especially in the short term.
- Monetary policy – Because the Fed will try to tame high inflation by raising interest rates, this will cause the prime rate – the rate used to calculate interest on all consumer products - to rise also. In other words, when the Fed increases its rate, consumers can expect the rates of mortgages, auto loans, credit cards, personal loans, etc. to also rise.
- Tax brackets – Every year when the IRS publishes its latest income ranges for each of its seven federal tax brackets, it uses inflation to determine how much they should be adjusted. This is also used for many other government programs such as the income level of who can contribute to a Roth IRA.
- Wage negotiation – As the cost of living rises, workers will naturally demand increased compensation. Businesses must take this into consideration when hiring new individuals, giving promotions, and giving pay raises to current employees.
The Bottom Line
The consumer price index is a useful way to quantify how much consumers are spending on typical goods and services. Changes in the CPI can indicate how much inflation the economy. Is currently experiencing. Consumers need to be aware of CPI and inflation because their significance affects everything from how far their money stretches to changes in monetary policy by the Federal Reserve.