CPI data is used to calculate inflation with the following general formula:
- CPI1 = initial CPI
- CPI2 = final CPI
- Inflation = (CPI2-CPI1)/CPI1
Since two CPI values define inflation, the consumer price index has a large effect on reported inflation.
CPI and Inflation Calculation
The following example will illustrate how different prices, baselines and CPI values affect reported inflation.
- Assume a mix of products with average product price indexed to CPI of 100 in a Baseline Year.
- Three years later, the same products have an average price index of 108. This means that three years after Baseline Year, buying the same product mix would take eight percent more money than it cost during Baseline Year. Note that this is not a reflection of product quality, but purely a function of decreased purchasing power of Baseline Year Dollars.
- Six years after Baseline Year, CPI is determined to be 130.
- InflationB-3, between Baseline and third year, would be calculated as (108-100)/100 = .08 or eight percent.
- Inflation3-6, between third and xixth years, would be (130-108)/108 = 0.204, or 20.4 percent
- InflationB-6 is: (130-100)/100 = 0.30 or thirty percent.
In this example, inflation calculations in three-year intervals were 8 and 20.4 percent. Yet, inflation over six years measured cumulatively was thirty percent. This was more than a summation of 8 and 20.4, which comes to 28.4 percent. As is evident here, clever choice of CPI data can give “honest” yet differing inflation figures.
Baseline CPI and Inflation
The choice of CPI baseline is arbitrary. A baseline that will give the most favorable results could be chosen over one that might be more accurate in reflecting the economic reality of shifting consumer purchasing power with respect to a basket of goods and services. For instance, baselines set during recessions or asset bubble peaks would both give very skewed inflation data.
The BLS calculates CPI from product price surveys in select metropolitan areas. More populated and economically dominant areas such as those centered around New York City and Los Angeles are weighed more heavily than smaller population clusters such as those centered on Memphis and Anchorage. Thus, economic realities prevalent for many people in small-town and rural areas will be under-represented in favor of large metropolitan areas.
CPI fails to take into account purchases of investment securities such as stocks. Recent U.S. financial history illustrates this phenomenon:
- The average CPI in 2009 was 214.537, increasing to 232.957 by 2013.
- 2009-2013 inflation comes to (232.957 – 214.537)/214.537 = 0.086, or 8.6 percent.
- The beginning price for the S&P 500 index in 2009 was 903.25.
- Ending S&P 500 price at the close of 2013 was 1848.36.
- The S&P 500 index rose (1848.36-903.25) / 903.25 = 1.046, or 104.6 percent.
Some experts have stated that the S&P 500’s meteoric rise between 2009 and 2013 was not justified by underlying economics, instead being a result of loose monetary policy on the part of the Federal Reserve. It was predicted that the money would percolate to consumer products, stoking inflation. This has not happened, with 8.6 percent inflation being rather mild in a four-year time period. Rather, the inflation” went into the stock market. As such, investors had to contend with the possibility that artificially inflated stock prices would make positive returns unlikely in the future.