Consumer Price Index and How It Measures Inflation

Why You Should Pay Attention to the Core CPI

Image by Emilie Dunphy © The Balance 2019

The Consumer Price Index is a monthly measurement of U.S. prices for most household goods and services. It reports inflation, or rising prices, and deflation, or falling prices.

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% 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.

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. It occurs when interest rates are low and housing prices are rising. 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 the CPI Is Important

The CPI measures inflation, one of the greatest threats to a healthy economy. It eats away at your standard of living if your income doesn't keep pace with rising prices. Over time, it increases your cost of living.

If the inflation rate is high enough, it hurts the economy. Since everything costs more, manufacturers produce less. Ultimately, they are forced to lay off workers.

The Federal Reserve uses the CPI to determine whether economic policies need to be modified to prevent inflation. When it recognizes inflation, the Fed uses contractionary monetary policy to slow economic growth before inflation develops. It changes the fed funds rate. This makes loans more expensive. It tightens the money supply, which is the total amount of credit allowed into the market.

The Fed's actions reduce the liquidity in the financial system, making it becomes more expensive to get loans. It slows economic growth and demand, which puts downward pressure on prices. That returns the economy to a healthy growth rate of 2% to 3% a year.

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.

Current CPI

The current CPI 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. 

Since the Recession, the Fed has been gradually increasing interest rates. That's kept inflation at bay.

Core Index

There are two measures of inflation. The first is headline inflation which includes everything measured by the BLS.

The second is core CPI which does not include food and energy cost. Core CPI is important because the Fed 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.

For example, 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 when the Fed uses expansionary monetary policy. They are concerned it could trigger inflation. But as long as the core CPI remains within the Fed's 2% target inflation rate, inflation is under control.

Historical CPI

The U.S. inflation rate by year shows that inflation used to be much worse. In 1946, it hit a record annual high of 18.1%. The economy had overheated due to World War II. In 1974, it was 12.3% at the same time the economy contracted 0.5%. That anomaly is called stagflation. In 1932, prices fell a record 10.3%. In 1930, Congress imposed the Smoot-Hawley Tariff. It created a trade war that lowered prices and worsened the Great Depression.

If you need historical CPI by month, you'll find it on the BLS website. The agency provides a history of the CPI for every month since 1912. The core CPI history is available for every month since 1956. The history of CPI by city or by product category can also be selected. 

Calculator

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.