Table of Contents
What is CPI?
What is CPI used for?
Who uses CPI?
How is CPI calculated?
Why CPI is controversial
The bottom line
Aug 23, 2022
7 min read
The CPI measures the changes in prices consumers pay, It is an indicator of inflation and is watched by the Fed in its decision to raise or lower interest rates for the economy.
The consumer price index (CPI) is a metric devised by theBureau of Labor Statistics to measure the change in the prices of household goods and services, including food, energy, transportation, housing, and medical care. The BLS calculates this figure to reflect an aggregate of U.S. consumer spending.
CPI is a key indicator of inflation and deflation in the U.S. economy. It is used by some to anticipate the cost of living in some areas of the country. It is also used by the government to make cost of living adjustments for federal employees and beneficiaries of Social Security payments, as well as to determine rises in consumer and commercial rents. It has additional applications for those who set prices on retail goods, as well as for those who buy them.
The CPI is a collection of pricing data gathered by the BLS to measure the weighted average (meaning more costly items count more) change in prices consumers pay for a basket of about 80,000 goods and services. The BLS constructs the market basket based on spending information it gathers from a survey of U.S. households.
The numbers represent the spending patterns of two groups: all urban consumers, and urban earners and clerical workers. To get a representative sample, it collects data in 75 urban areas around the country and from 23,000 businesses each month, as well as data on rents (including owner-occupied housing) from 50,000 landlords and tenants.
To index the CPI numbers, the BLS uses 1982-84 as a basis. In doing this, the agency sets the base year index to 100, and uses subsequent periods to calculate how much prices rose or fell.
CPI has many applications, and is used by businesses and individuals for a wide variety of purposes.
CPI is the most widely tracked indicator of inflation, and the Federal Reserve takes it into account in making monetary policy. The BLS releasesmonthly numbers, which show the price changes for the month, seasonally adjusted, and for the past 12 months. In June 2022, the CPI rose 9.1% over the prior 12 months, as inflation approached a 41-year high. This inflation in prices of goods and services results in a reduction in consumer purchasing power.
The CPI is used to calculate cost of living increases for federal employees, Social Security beneficiaries, and military and civil service retirees. The government also uses it to calculate the cost of school lunches and the benefits for those who qualify for food stamps.
The CPI is used by the government to prevent increases in taxes that result from wage increases to keep up with inflation, a phenomenon known as “bracket creep.”
Businesses often use CPI numbers to determine how much to charge for goods and services similar to those measured by the index.
A number of important government agencies as well as corporations and consumers turn to the CPI for information about the state of the economy, including:
. The U.S. central bank pays close attention to CPI, using it to inform changes in short-term interest rates. The CPI showed consistent and rising inflation in 2021 and the first half of 2022, leading the Fed to increase interest rates four times in the first half of the year to try and cool inflation.
The SSA uses theCPI for urban wage earners and clerical workers (CPI-W) to determine cost of living adjustments (COLAs) for Social Security beneficiaries.
Those who own or manage retail businesses may use prices for goods or services measured by CPI to determine when and how much to raise their own prices.
Consultants who advise clients on investing for retirement and taxes may use CPI to make adjustments to investing strategies.
Consumers pay attention to CPI because the changes in prices—especially dramatic increases—influence spending and other consumer behavior.
CPI represents the average change in prices that consumers will spend on a basket of goods and services over time. It can compare the prices to a previous year, previous month, or the base month. The formula to express the change as a percentage is:
Cost of current goods or services/cost of goods or services in a previous period x 100 = CPI
Once you know how to calculate CPI using this formula, you can calculate the price changes in anything, provided the goods or services from the past are comparable to today’s. (You can also use theBLS CPI calculator to see the buying power of a certain price in a past year compared to another year.) Here is a step-by-step guide on how to calculate CPI:
Find a number that represents a past purchase. Take, for instance, one bottle of hand soap you bought in 2017 for $3, two pounds of bacon for $3 each, and one gallon of milk for $4. This basket of goods totaled $13 in 2017.
Subtract 100 from the final number, which represents the index baseline and shows the change in pricing from the base. The current prices would be 169% of the previous prices (169/100). But the CPI, which is the number adjusted for the baseline, is 69%. The full formula would be: 22/13 = 1.69 x 100 = 169 - 100 = 69 or 69%. A positive number represents inflation, and a negative number would represent deflation.
Although CPI is a key indicator of inflation, it has limitations. The CPI is based on prices of food, clothing, shelter, energy, transportation, and medical services, as well as other goods and services that most people buy. It does not represent all consumption in the economy, and some economists argue that biases built into CPI lead to an over- or understatement of inflation.
Here are a few of the ways the CPI might not capture certain price information:
Economists have argued in the past that some of these biases have led to overstatement of inflation. Because BLS introduced some corrections for these biases in 1996, some now believe CPI understates inflation.
The Fed and Social Security Administration use the CPI for important policy decisions—so over- or understating CPI (and therefore, public perceptions of inflation)—may be problematic for public policy decisions.
The CPI measures the changes in prices consumers pay for a basket of goods and services over a certain period. It is an important indicator of inflation and is watched closely by the Fed in its decision to raise or lower interest rates to cool or stimulate the economy. It is also used by the Social Security Administration to determine cost of living increases, by financial professionals to guide investors, and for anyone to calculate for inflation. Understanding the CPI can help people gauge the significance of price changes for the health of the economy and their personal finances.
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