Consumer Price Index: How It's Calculated, Why It's Important
How the Government Measures Inflation
The Bureau of Labor Statistics surveys the prices of 80,000 consumer items to create the index. It represents the prices of a cross-section of goods and services commonly bought by primarily urban households. They represent 87 percent of the U.S. population.
How the CPI Is Calculated
The BLS collects price information from 23,000 retail and service companies. It chooses the types of businesses frequented by a sample of 14,500 families. The CPI includes sales taxes. It excludes income taxes and the prices of investments such as stocks and bonds. The complete list of everything it does measure is on the BLS website. It also shows the change in price for each item in 26 of the 87 cities measured. (Source: "Frequently Asked Questions," BLS.)
Note that the CPI does not include sales price of homes. Instead, it calculates the monthly equivalent of owning a home, which it derives from rents. That's misleading. Rental prices are likely to drop when there is a high vacancy rate. That typically occurs when interest rates are low, and housing prices are rising. That's because people are more likely to buy houses when the market is improving.
Conversely, home prices fall when interest rates rise.
As the housing market deteriorates, people move into apartments. That makes rents increase. As a result, the CPI gives a false low reading when home prices are high and rents are low. That's why it did not warn of asset inflation during the housing bubble of 2005.
Why It's Important
The CPI measures inflation, one of the greatest threats to a healthy economy.
Therefore, the Federal government uses it to determine whether economic policies need to be modified to prevent inflation. Second, government agencies use the CPI to adjust prices in other government economic indicators, such as gross domestic product. Third, the government uses it to improve benefit levels for recipients of Social Security and other government programs.
Currently, the Consumer Price Index does not indicate a threat from inflation. Why not? First, low-cost Chinese imports and technology improvements have kept prices down for the last decade. Second, the Great Recession depressed economic growth. That lowered demand and prevented businesses from raising prices. Instead, they cut costs, resulting in high unemployment. For the latest numbers, see Current Inflation Rates.
There are two measures of inflation. The first is core CPI, which does not include food and energy cost. Headline inflation, or non-core CPI, includes everything. Core CPI is important because the Federal Reserve considers it when deciding whether or not 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.
Therefore, inflation could be high if gas prices have risen, but the Fed won't react until those increases trickle through to the prices of other goods and services.
Many worry that the Fed's expansionary monetary policy will trigger inflation. As global demand rises, inflation could once again rear its ugly head. Fortunately, the core CPI is still within the Fed's 2 percent target inflation rate.
You can find historical CPI numbers on the BLS website. The agency provides a history of the Consumer Price Index for every month since 1912. The monthly history of the core CPI is available for every month since 1956. The history of CPI by city or by product category can also be selected. See U.S. Inflation Rate by Year since 1929, compared to GDP, the unemployment rate, and the fed funds rate.
The BLS publishes a handy inflation calculator. You can plug in the dollar value for any year from 1913 to the present, and it will tell you what it's worth for any year from 1913 to the present. It uses the average Consumer Price Index for that calendar year. For the current year, it uses the latest monthly index. To try it out, go to CPI Inflation Calculator. If you don't want to do the work yourself, I've done it for you for every decade since 1913 in What Is the Value of a Dollar Today?