Consumer Price Index and How It Measures Inflation
Why You Should Pay Attention to the Core CPI
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, 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
CPI and inflation are often used interchangeably, as inflation is the percentage increase or decrease of CPI over a certain period of time.
What's in the CPI Basket?
The basket represents the prices of a cross-section of goods and services commonly bought by urban households. The cross-section represents around 93% of the U.S. population, and factors in a sample of 14,500 families and 80,000 consumer prices.
Here are the major categories in the basket and how much each contributed to the CPI as of November 2020:
|Consumer Price Index Categories|
|Energy (Incl. Gasoline)||6%|
|Commodities (Incl. Medication and Autos)||20%|
For those who own their homes, the CPI calculates the owner's equivalent of primary residence (OER) instead of the monthly mortgage payment. The OER is what the owners predict how much 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.
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 the CPI Is Calculated
The BLS computes the CPI by taking the average weighted cost of a basket of goods in a month and dividing it by the same basket the previous month. It then multiplies this percentage by 100 to get the number for the index.
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 December 2020 the index was 260.5. That's how much prices have increased since the base period of 1982 to 1984 was established at roughly 100.
The BLS conveniently publishes the percentage change since last month or last year. In December 2020, prices rose by 0.4% from November. In November 2020, there was an increase of 0.2% in the index from October of 2020.
The CPI for December 2020 was 0.4% higher than November 2020 and increased by 1.4% from December 2019.
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.
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.
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.
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.
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. 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 could depress the stock market.
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. 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.
Historical CPI & Inflation
The U.S. inflation rate by year shows that fluctuations in CPI used to be much worse. In 1946, inflation hit a record annual high of 18.1% year-on-year.
Inflation 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. The calculator will tell you what the dollar amount is or was 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.
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