With inflation reaching 40-year highs in the United States in 2022, many people have been hearing more and more about the Consumer Price Index (CPI) in the news. And while many of us understand that the CPI is an economic indicator, not everyone knows what it covers or how it impacts their budget.
To keep up with current events and boost your overall financial and economic literacy, it’s helpful to learn the basics of the Consumer Price Index. With that in mind, here’s a look at what the CPI is, how it works, what it measures and how it may impact your budgeting strategy.
The CPI is a metric that measures the change of the price of specific goods and services in urban consumer markets around the United States. It tracks a “basket” – a collection of goods and services that are deemed representative of consumer spending patterns.
These price data are collected from a subset of consumers who stand in for typical shoppers in the nation, along with pricing data from retailers and service providers. Those data sets give the U.S. Bureau of Labor Statistics information about what products and services to include in the basket, as well as recent pricing for those selected items and services. During the analysis, the data are aggregated to monitor inflation and deflation.
The CPI is considered a lagging indicator, similar to unemployment data reports. Information about spending isn’t collected and assessed in real time. Instead, the data are first collected, then assessed for further analysis. As a result, CPI data is more reflective of recent history than the current state of the economy.
However, the delay is often relatively small. For example, the May 2022 CPI report was released in mid-June. Still, this means it isn’t wholly reflective of current pricing, though many economists still consider the information recent and highly relevant.
How the Consumer Price Index Works and How It’s Calculated
Functionally, the CPI is a weighted average of the cost of a specific basket of goods and services that acts as a representation of consumer spending. As mentioned above, its main purpose is to allow for the monitoring of inflation and deflation.
The CPI works by collecting spending data from a select group of individuals who are deemed representative of the broader population and from retail pricing for goods and services. This differs from the Producer Price Index (PPI), which measures price changes for goods producers and service suppliers. This means the CPI shows how much consumers have to pay for the items and services in question.
When the data are analyzed, they include costs like sales taxes, excise taxes and user fees. This makes the data more reflective of what consumers pay at checkout, or what’s actually leaving their bank accounts when they pay for something. Those expenses can dramatically impact household budgets, especially when budgeting for inflation.
What the Consumer Price Index Measures
As mentioned above, the CPI tracks a basket of goods and services that are designed to reflect household spending. The composition of the basket is updated over time using data collected from consumers to see precisely what people are purchasing. If a particular category is seeing far more activity, it’s more likely to become part of the basket. If spending activity in a category declines, it may be removed from the basket.
For example, housing is typically always part of the basket; it’s a major spending category for nearly every household. For grocery items, purchasing habits change. One month, cereal may be highly popular, but that may not be the case the next month.
The composition of the basket is designed to be objectively selected, relying on metrics to determine whether a good or service makes the cut. It’s also somewhat general. For example, the CPI typically lumps all cereals together, causing a variety of brands and products to fall into one grouping.
There are CPI reports that include other factors, too. For example, along with broad reports, narrowed-down versions may reflect spending patterns for specific population segments or physical locations.
What Is the Consumer Price Index Used For?
Generally speaking, the CPI is an economic indicator that measures inflation and deflation. It allows government agencies to determine the effectiveness of various policies aimed at curbing high inflation or deflation. Additionally, it shows how price changes may impact spending and household budgets in the near future.
The CPI is commonly used in shaping monetary policies. For example, when the Federal Reserve makes decisions about interest rates, it uses data from the CPI to ensure inflation and deflation are appropriately factored into the equation.
With the CPI, agencies can also assess changes to the purchasing power of a dollar. It allows them to see how far a dollar can go in regards to consumer spending. This then tells them whether the cost of goods and services is keeping pace with wages or how the U.S. economy is faring when compared to other countries’ economies.
In some cases, the CPI alters certain income payments. For instance, Social Security payments may go up if the CPI shows that the cost of goods and services is rising. It’ll also lead to wage changes for individuals who are eligible for cost-of-living adjustments, such as federal employees and military personnel.
The CPI can also lead to adjustments to federal income tax structures. With these, the aim is to avoid inflation-related increases to tax rates. At times, the reports also alter eligibility for various programs, such as SNAP, free school lunches and others.
Why Is the Consumer Price Index Controversial?
While the CPI is often touted as an objective metric, some believe it can overstate or understate inflation and deflation. Generally, this is because there’s some debate about the best way to measure inflation and deflation.
When it was initially designed, the CPI was a cost of goods index (COGI). However, after revisions, it became a cost of living index (COLI). According to the Bureau of Labor Statistics, the shift was designed to eliminate biases that would lead to inaccurate reflections of inflation and deflation. However, some feel that the changes allow the CPI to report lower numbers in regard to inflation. As a result, certain economists view it as data manipulation, though others disagree.
Additionally, by sticking with a basket, not all price changes are taken into account. While managing and analyzing that amount of data would be cumbersome, to say the least, it could mean that a potentially critical factor is omitted.
Ultimately, while the CPI may not be a perfect picture of consumer economic conditions, it still lets people track general price movements. As a result, the Consumer Price Index remains a powerful tool, even if it may be slightly flawed.