The Consumer Price Index (CPI) is a popular measure for determining inflation and deflation and providing an overall look at the purchasing power of a currency. CPI as an economic indicator has its proponents and detractors, but it is widely used as a snapshot of how a nation’s economy affects the average consumer’s cost of living.
What Is the CPI, and How Is It Calculated?
CPI measures the average change over a period of time in prices paid by consumers for a “basket” of consumer goods and services. The basket is determined by surveys and diaries collected from average consumers, and is based on the most commonly purchased items and services.
In the United States, the CPI is based on an index that covers over 90% of the overall U.S. population. It includes over 80,000 price quotes from 23,000 retail outlets and service providers. Also included are housing rents from 50,000 rental units to determine the average housing price paid by consumers.
The CPI price basket draws from eight groups of purchases, each given a particular weight according to how much the average consumer spends on items in that group. The groups are Housing, Apparel, Transportation, Education & Communication, Food and Beverages, Medical Care, Recreation, and Other, which covers anything not included in one of the other categories. Housing costs receive the most weight, accounting for about 33% of the basket’s total.
CPI has subdivisions, the most popular and widely used one being CPI – U which covers urban consumers. This particular statistic accounts for the over 90% of the U.S. population cited above.
CPI is normally based on a yearly figure. It is calculated by dividing the current basket value by the basket value of the previous year. The result is reported as a whole number. This provides a basis of comparison that illustrates the purchasing power of a currency at the present time.
By itself, CPI is an interesting look at consumer spending, but it is most useful for determining the rate of inflation. The inflation rate is calculated by subtracting the previous CPI from the current CPI and then dividing that result by the previous CPI. The result is reported as a percentage, which is usually positive, indicating that the price of goods and services is increasing. Inflation can be calculated annually, but it is also calculated monthly for a more immediate look. This way, inflationary trends can be identified quickly.
How Is CPI Used by Governments and the Financial Sector?
Financial markets use CPI to gauge inflation. Investors can identify trends in spending and price changes and react accordingly. Government institutions, like the Federal Reserve of the United States, analyze CPI and other inflation measures to help formulate monetary policy.
For example, the Federal Reserve targets a 2% inflation rate as most desirable for the economy. If the rate rises above this target, the Fed may increase interest rates to try to bring inflation down. Conversely, a lower inflation rate typically prompts the Fed to cut interest rates to jumpstart a sluggish economy.
The Fed also analyzes CPI in relation to unemployment. Normally, CPI is inversely related to the unemployment rate. That is, a higher CPI means low unemployment, while a lower CPI tends to see more people out of the workforce. Federal Reserve policies try to balance inflation and unemployment to create a happy medium.
Many have criticized the CPI and its use in influencing both government and financial policies. One of the main criticisms of CPI is that it overstates inflation, leading to policies that overreact to the actual situation. The CPI also is not very reliable for gauging the cost of living in rural areas. The CPI is almost totally based on urban consumers, and there can be considerable differences between urban and rural areas in terms of prices for goods and services. A 1995 U.S. Congressional Panel agreed with these criticisms of CPI, adding a governmental voice to those of critics from the private sector.
CPI has also attracted criticism because it does not differentiate between the purchasing habits of consumers from different income levels. For example, lower-income consumers tend to spend a much greater percentage of their money on necessities like food and housing, while higher-income consumers use a larger percentage of their spending on recreation. The CPI is calculated from a “one size fits all” basket, and thus does not account for these different purchasing patterns.
Even with these limitations and flaws, the Consumer Price Index is still an interesting, broad snapshot of how much consumers at paying for their goods and services at a particular point in time. It can be compared to earlier CPI numbers as a rough measure of inflation that is more easily understood by the general public than some other, more complex measures. It is not, however, a universally applicable statistic, and should be considered along with other figures to arrive at a true picture of inflation and the cost of living.