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CPI

What exactly is the Consumer Price Index (CPI) and how is it calculated?

by | Nov 5, 2014 | Definitions

cpiCPI stands for Consumer Price Index, and it is a measure of inflation. It is calculated by measuring the change in a specific group of goods and services over time. The CPI is calculated by the US Bureau of Labor Statistics.

What the CPI Measures

The CPI measures the spending habits for two different groups. The CPI-U measures the spending patterns of all urban consumers. The CPI-W measures the spending patterns of urban wage earners and clerical workers. The spending patterns of people living in rural areas, farmers, members of the armed forces and those institutionalized in prisons or hospitals are not measured. The group of all urban consumers represents about 87 percent of the entire population of the United States. The people who comprise the CPI-W are a subset of the CPI-U.

What the CPI Includes

The CPI includes eight major groups of expenditures. They are:

  • apparel, which includes clothing and accessories like jewelry;
  • education and communication, which includes school tuition, telephone and internet services, and computer software and accessories;
  • food and beverages, which consists of grocery items as well as dining out;
  • housing, which includes rent or mortgage payments, utilities and furnishings;
  • medical care, including prescriptions, hospital services, doctor’s services, and dental and vision products and services;
  • recreation, including admission to spectator sporting events, toys, pets, and sports equipment;
  • transportation, comprised of vehicle leases and purchases, gas, insurance, and airplane and train fares; and
  • other goods and services, such as personal services like hairdressing, funeral expenses, and tobacco and smoking products.

Taxes on items purchased and excise taxes are included in CPI, as are user taxes like tolls. Income taxes are not included. Investments and savings vehicles are not included.

How the CPI Data is Published

The CPI data is published nationally and by region every month. The regions are the Northeast, Midwest, South and West. The data is also published by metropolitan area. The Chicago, Los Angeles and New York data are published every month. Data for the other 11 metropolitan areas are published every other month. These areas are Atlanta, Boston, Cleveland, Dallas, Detroit, Houston, Miami, Philadelphia, San Francisco, Seattle and Washington DC.

How the CPI is Used

The CPI is used to measure inflation. It is used by government agencies and entities to measure the effectiveness of fiscal and monetary policy, and to determine when that policy needs to be adjusted. It is used by government, private industry, labor unions and individuals to determine how effective current economic policy is.

The CPI is used to determine purchasing power. When you hear the terms ‘in today’s dollars,’ or ‘adjusted for inflation,’ the values discussed have been adjusted by using the CPI in order to reflect true purchasing power, or the amount a dollar will buy, at different times in history.

The CPI is used to adjust Social Security and other income payments, and to adjust the level of income required for eligibility for government programs. Retirees, whether they collect Social Security or a military or civil service pension, recipients of food stamps, and children who receive free or reduced price school lunches are all affected by changes in the CPI.

The Difference Between CPI and a Cost-of-Living Index

The CPI is often referred to as a cost-of-living index, but there is a difference. The CPI reflects what consumers are actually buying, while a cost of living index reflects the amount of income necessary to maintain a certain standard of living.

When consumers have less income, they tend to substitute less expensive versions of the same item in their budgets. Since the CPI reflects the cost of what they actually buy, this measure may drop when substitutions are made. A cost of living index, on the other hand, would reflect the cost of a certain item over time, which will almost always go up.

How Does CPI Affect Inflation?

by | Oct 5, 2014 | Definitions

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.

Qualitative Discrepancies

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.

Conclusion

CPI has a large effect on inflation calculations. CPI is great overall catchall of consumer purchasing power over time, though it has some weaknesses. Also, it is important to note that CPI ignores some facets of consumer purchases, such as investment vehicles, that have a substantial effect on future purchasing power and quality of life.