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 make sure economic growth remains stable. If it detects too much inflation or deflation, it has many monetary policy tools it can use 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 contributes to the CPI.

Group Weight
Food 14.2%
Energy (Incl. Gasoline)   5.8%
Commodities (Incl. Medication and Autos)  20.3%
Housing  33.5%
Health Care   7.4%
Transportation    5.1%
Other Services 23.3%
TOTAL 100%

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

The CPI does not include sales price of homes.

Instead, it calculates the owner's equivalent of primary residence (OER). That's what the owners would have had to pay if they were renting the home.

The OER can often be misleading. Rental prices drop when there is a high vacancy rate. That 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.

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 cost of the same basket for 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 May 2020 the index was 256.394. 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 May 2020, the seasonally adjusted percentage change since April 2020 was -0.1%. That means prices dropped by that amount in a month.

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 too high, it hurts the economy. Since everything costs more, manufacturers produce less. Ultimately, they are 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. 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.

How the CPI Affects Other Government Agencies

The Bureau of Economic Analysis uses the CPI to adjust prices in other economic indicators, such as gross domestic product.

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.

When the CPI jumps, it 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.

That increases interest rates. That costs businesses more to borrow money to expand. The net effect is a decrease in earnings, which depresses the stock market.

Core CPI

The CPI measures two commodities that often swing wildly. They are food and energy, 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.

Core CPI solves the problem of volatile food and energy prices by excluding them.

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.

Current CPI

The current CPI does not indicate any 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. After the recession, the Fed gradually increased interest rates. That kept inflation at bay.

In 2020, the Fed lowered rates to combat the 2020 recession. The COVID pandemic kept people at home, decreased demand, and triggered a mild deflation.

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.

The second-highest record was in 1974. It hit 12.3% at the same time the economy contracted 0.5%. That anomaly is called stagflation.

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

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

  1. Bureau of Labor Statistics. "Consumer Price Index." Accessed July 3, 2020.

  2. U.S. Bureau of Labor Statistics. "Consumer Price Index Frequently Asked Questions." Accessed July 3, 2020.

  3. U.S. Bureau of Labor Statistics. "Table 1. Consumer Price Index for All Urban Consumers (CPI-U): U. S. City Average, by Expenditure Category." Accessed July 3, 2020.

  4. U.S. Bureau of Labor Statistics. "How the CPI Measures Price Change of Owners' Equivalent Rent of Primary Residence (OER) and Rent of Primary Residence (Rent)." Accessed July 3, 2020.

  5. Bureau of Labor Statistics. "Chapter 17. The Consumer Price Index (Updated 2-14-2018)," Page 18. Accessed July 3, 2020.

  6. Bernard Baumol. "The Secrets of Economic Indicators, Third Edition," Page 305-316. Pearson Education, 2013. Accessed July 3, 2020.