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 (CPI) is a monthly measurement of U.S. prices for household goods and services. It reports inflation, or rising prices, and deflation, or falling prices. Both can seriously erode a healthy economy.

The Federal Reserve, the U.S. central bank, monitors price changes to ensure economic growth remains stable. If the Federal Reserve detects too much inflation or deflation, it uses monetary policy tools to intervene.

What Is the CPI?

The CPI is the U.S. government's measurement of price changes in a typical basket of goods and services bought by urban consumers.

  • Alternate Name: CPI for All Urban Consumers (CPI-U).
  • Acronym: CPI

How the CPI Is Calculated

Each month, the Bureau of Labor Statistics (BLS) surveys the prices of 80,000 consumer items to create the index. It collects this price information from thousands of retail and service companies. It chooses the types of businesses frequented by a sample of 14,500 families.

What's in the CPI Basket?

The basket represents the prices of a cross-section of goods and services commonly bought by urban households. They represent 93% of the U.S. population.

Here are the major categories in the basket and how much each contributed to the CPI as of July 2020.

Consumer Price Index Categories
Group Weight
Food 14%
Energy (Incl. Gasoline)   6%
Commodities (Incl. Medication and Autos)  20%
Housing  33%
Health Care   7%
Transportation    5%
Other Services 15%
TOTAL 100%

The CPI does not include the sales price of homes. Instead, it calculates the owner's equivalent of primary residence (OER), or what the owners would've paid if renting the home from someone else.

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.

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.

This is why the CPI didn't warn of asset inflation during the housing bubble of 2005.

The CPI includes sales taxes. It excludes income taxes and the prices of investments, such as stocks and bonds.

How Is the Index Calculated?

The BLS computes the CPI by taking the average weighted cost of a basket of goods for this month and dividing it by the same basket last month. It multiplies this percentage by 100 to get the number for the index.

CPI Formula

Consumer Price Index =

Cost of Basket (This Month) / Cost of Basket (Last Month) X 100

The index shows how much the prices have changed since the base year of 1982. For example, in August 2020 the index was 259.9. That's how much prices have increased since 1982 when they were set at 100.

The BLS conveniently publishes the percentage change since last month or last year. In August 2020, the seasonally adjusted percentage change since July 2020 was 0.4%. That means prices rose by 0.4% in a month.

Why the CPI Is Important

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. Over time, your cost of living increases.

A high inflation rate can hurt the economy. Since everything costs more, manufacturers produce less and may be forced to lay off workers.

How the CPI Affects the Fed

The Fed uses the CPI to determine whether economic policies need to be modified to prevent inflation. In the past, when recognizing inflation was on the horizon, the Fed used contractionary monetary policy to slow economic growth. It changed the fed funds rate to make loans more expensive, which tightened the money supply–the total amount of credit allowed into the market.

Slowed economic growth and demand put downward pressure on prices and returned the economy to a healthy growth rate of 2% to 3% a year.

However, on Aug. 27, 2020, the Federal Reserve announced a change–it will allow a target inflation rate of more than 2% to help ensure maximum employment. Over time, 2% inflation growth is preferred, but the Fed is willing to allow higher rates if inflation has been low for a while.

How the CPI Affects Other Government Agencies

The government uses the CPI to improve benefit levels for recipients of Social Security and other government programs.

How the CPI Affects Housing and Investments

Landlords use the CPI forecasts to determine future rent increases in contracts.

An increased CPI can depress bond prices. All fixed-income investments lose value during inflation. As a result, investors demand higher yields on these investments to make up for the loss in value.

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 depresses the stock market.

Core CPI

The CPI measures two commodities with wild price swings–food, and energy commodities such as 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. As a result, the CPI often reflects these price swings.

The core CPI solves the problem of volatile food and energy prices by excluding food and energy. In the past, the Fed considered core CPI 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. 

For example, inflation could be high if gas prices have risen. But the Fed didn't react until those increases impacted the prices of other goods and services.

August 2020 CPI

The August 2020 CPI doesn't indicate any threat from inflation. For the last several decades, low-cost Chinese imports and technology improvements have kept prices down.

Second, the Great Recession's depressed economic growth lowered demand and prevented businesses from raising prices. Instead, businesses cut costs, resulting in high unemployment. After the recession, the Fed gradually increased interest rates to keep inflation at bay.

In 2020, the Fed lowered rates to combat the 2020 recession, when the COVID-19 pandemic kept people at home, decreasing demand. This initially triggered a mild deflation.

Historical CPI

The U.S. inflation rate by year shows that inflation used to be much worse. In 1946, inflation hit a record annual high of 18.1%, due to an overheated economy resulting from World War II.

Inflation next broke a record in 1974, when it hit 12.3% while the economy contracted 0.5%. That anomaly is called stagflation.

Deflation occurred in 1932 when prices fell a record 10.3%. Congress had imposed the Smoot-Hawley Tariff two years earlier, which created a trade war that lowered prices and worsened the Great Depression.

Inflation 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. 

Article Sources

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