The consumer price index (CPI) is a monthly measurement of U.S. prices for household goods and services. It reports inflation (rising prices) and deflation (falling prices). Both can hurt a healthy economy.
The Federal Reserve monitors price changes to ensure economic growth remains stable. The Federal Reserve uses monetary policy tools to intervene if it detects too much inflation or deflation.
Definition and an Example of CPI Calculation
The CPI is the U.S. government's measurement of price changes in a typical "basket" of goods and services that are bought by urban consumers.
The Bureau of Labor Statistics (BLS) computes the CPI by taking the average weighted cost of a basket of goods in a given month and dividing it by the weighted cost of the same basket the previous month. It then multiplies this percentage by 100 to get the number for the index.
The equation works like this: Consumer Price Index = Cost of Basket (This Month) / Cost of Basket (Last Month) X 100.
The terms CPI and inflation are often used interchangeably because inflation is the percentage increase or decrease of CPI over a certain period of time.
The index shows how much prices have changed since the base year of 1982. The index was 271.7 in June 2021. That's how much prices have increased since the base period of 1982 to 1984 was established at roughly 100.
The BLS publishes the percentage change since last month or last year. Prices rose by 0.9% from May 2021 to June 2021. There was an increase of 0.6% in the index from April 2021 to May 2021. The CPI increased by 5.4% from June 2020.
- Alternate Name: CPI for All Urban Consumers (CPI-U)
- Acronym: CPI
How the CPI Works
The basket represents the prices of a cross-section of goods and services that are commonly bought by urban households. This cross-section represents around 93% of the U.S. population, and it factors in a sample of 14,500 families and 80,000 consumer prices.
These are the major categories in the basket, and how much each contributed to the CPI as of May 2021.
|Consumer Price Index Categories|
|Energy (Incl. Gasoline)||7%|
|Commodities (Incl. Medication and Autos)||20%|
The CPI calculates the owner's equivalent of primary residence (OER) instead of the monthly mortgage payment for those who own their homes. The OER is what the owners use to predict how much the rent would be if they rented the home.
The CPI could give a false low inflation reading due to low rents, even when home prices are high. Low rents can result from fewer renters and increased vacancies as low interest rates spur more home purchases. At the same time, housing prices could rise due to increased market activity. This is why the CPI didn't warn of asset inflation during the housing bubble of 2005.
Conversely, rising interest rates might lead to fewer buyers in the market and falling home prices. As more people compete for apartments, rents go up.
The CPI includes sales taxes. It excludes income taxes and the prices of investments, such as stocks and bonds.
The CPI measures two commodities with wild price swings: food and energy commodities (oil and gasoline). These products are traded constantly on the commodities market. Traders can bid prices up or down based on news such as wars in oil-producing countries or droughts. The CPI often reflects these price swings as a result.
The "core" CPI solves the problem of volatile food and energy prices by excluding them. The Fed has considered core CPI in the past when deciding whether to raise the fed funds rate. The core CPI is useful because food, oil, and gas prices are volatile, and the Fed's tools are slow-acting.
How CPI Affects the Fed
The Fed uses the CPI to determine whether economic policies need to be modified to prevent inflation.
It used contractionary monetary policy to slow economic growth when it recognized that inflation was on the horizon. It changed the fed funds rate to make loans more expensive, tightening the money supply—the total amount of credit allowed into the market. Slowed growth and demand put downward pressure on prices. It returned the economy to a healthy growth rate of 2% to 3% a year.
The Federal Reserve announced a change on Aug. 27, 2020, to allow a target inflation rate of more than 2% to help ensure maximum employment. Inflation growth of 2% is preferred over time, but the Fed is willing to allow higher rates if inflation has been low for a while.
How CPI Affects Other Government Agencies
The government uses the CPI to improve benefit levels for recipients of Social Security and other government programs that provide financial assistance.
How CPI Affects Housing and Investments
Landlords use the CPI forecasts to determine future rent increases in contracts.
An increased CPI can depress bond prices, too. Fixed-income investments tend to lose value during inflation. Investors demand higher yields on these investments to make up for the loss in value as a result.
These yield demands can increase interest rates, which then increases costs for businesses borrowing money to expand. The net effect is a decrease in earnings, which could depress the stock market.
The U.S. inflation rate by year shows that fluctuations in CPI used to be much worse. Inflation hit a record annual high of 18.1% year-on-year in 1946. It next broke a record in 1974 when it hit 12.3% year-on-year while the economy contracted 0.5%. That anomaly is called stagflation.
Deflation occurred between 1930 and 1933. Prices fell 10.7% in September 1932 compared to September 1931. Congress had imposed the Smoot-Hawley Tariff two years earlier, which created a trade war that lowered prices and worsened the Great Depression.
The BLS publishes a handy inflation calculator you can use to plug in the dollar value for any year from 1913 to the present. It will tell you what the dollar amount is or was worth for any of those years using the average CPI for that calendar year.
Benefits of the CPI
The CPI measures inflation, which is one of the greatest threats to a healthy economy. Inflation eats away at your standard of living if your income doesn't keep pace with rising prices. Your cost of living increases over time.
A high inflation rate can hurt the economy. Everything costs more, so manufacturers produce less and may be forced to lay off workers. The CPI allows us to gauge these factors.
- The consumer price index measures and reports the effect of inflation and deflation on the economy.
- The Bureau of Labor Statistics calculates the CPI and publishes percentage changes.
- The CPI can occasionally give false readings due to variables in the current economy.
- The Fed uses the CPI to determine whether to modify economic policies to prevent inflation.