What is the Consumer Price Index (CPI)?
The Consumer Price Index (CPI) tracks how the price of a basket of goods changes over time as a way of measuring inflation.
The Consumer Price Index (CPI) is one way that the government keeps track of how the price of consumer goods is changing. It’s a measure of inflation (a general increase in prices) determined by calculating the average cost of selected items at regular intervals. The Bureau of Labor Statistics is in charge of tracking these price movements. Changes in the CPI define inflation rates that are used by the Federal Reserve, the nation’s central bank, and government agencies to help keep the economy on track. If the CPI indicates that inflation is too high or too low, the government can implement monetary policy (affecting the supply of money) or fiscal policy (changing tax rates or spending levels) to help push overall prices back to a more acceptable level.
Say you stumble upon an old pay stub of your grandfather’s from 1959. It says he made $450 for two weeks of work, meaning he earned $11,700 a year. You always thought your grandparents made a pretty good living, so you’re shocked at how little he got paid.
But the purchasing power of money (how much you can buy with the same amount of cash) has changed a lot in the last 60 years. To compare his paycheck to yours correctly, you need to convert his pay into 2019 dollars.
According to the Bureau of Labor Statistics, CPI was an average of 29.1 for 1959 and 257.2 for Nov. 2019. To adjust your grandfather’s pay into 2019 dollars, you need to divide the earlier CPI value by the later one and multiply the result by the amount of money you’re converting:
2019 CPI / 1959 CPI x 1959 salary = 2019 salary 257.2 / 29.1 x $11,700 = $103,410
So, your grandpa’s salary was equivalent to $103,410 today.
The Consumer Price Index is like a shopping list…
If you go to the store every month and buy the exact same items every time, you can record the total cost of your shopping trip to see if groceries are getting more expensive. The price of some items will likely go up, while other things might get cheaper (although overall prices trend upward over time). Tracking the total cost will tell you if you need to adjust your budget for the future.
The Bureau of Labor Statistics, a government agency that’s part of the US Department of Labor, tracks some important economic indicators, such as inflation (the general increase in prices over time). One of its most popular inflation statistics is the Consumer Price Index (CPI).
To calculate an index value, like the CPI, you first need to choose a base year. Everything else is calculated relative to that base. The BLS uses average prices from 1982 to 1984 as its base period. (There’s nothing magical about these years — It’s just what the agency uses.) Then, it calculates the index by dividing the target value (the number it cares about) by the base value. This number is then multiplied by 100 to make it easier to read. The formula is:
CPI = Target Year Prices / Base Year Prices X 100
To get a handle on inflation, you need a broad sample of prices. That’s why the BLS looks at a “basket of goods” that people commonly buy, from milk to movie tickets. The basket is a big enough sample to indicate the general direction of prices.
Imagine a set of common items cost the following over the last decade:
To calculate the index, first select a base year. Let’s use 2012 (you can use any base year you want). To determine the index value of all the other years, relative to 2012 prices, divide each year’s price by the 2012 value of $61.15.
The index value tells you how much things have changed between years, using the base year as the measurement of change. So, you could interpret the 2019 index value of 112.6 as meaning that prices are 112.6% of 2012 values. Put another way, prices have increased 12.6% since 2012.
When economists use the term “real price,” they mean that the price has been adjusted for inflation. Converting a price into a real price is a mathematical exercise. All you need is the CPI for the two years in question.
The CPI has everything indexed to the average costs between 1982 and 1984. So the index value tells you how prices have changed between then and the year in question.
For example, the CPI for 2014 was 236.74. That means that prices in 2014 were 236.74% of their average 1982-1984 costs. You could say that the total inflation rate over those 32 years was 136.74% (the starting price of 100% plus 136.74%).
To determine the rate of inflation between any two years, the formula is:
Inflation Rate = ((Final CPI Value - Initial CPI Value) / Initial CPI Value) * 100
For example, the CPI in 2015 was 237.02. To determine the rate of inflation between 2014 and 2015, you get:
((237.02 - 236.74)/236.74) * 100 = 0.12%
In other words, the inflation rate in 2015 was 0.12%.
There are two main reasons the Consumer Price Index measure is important. First, the government is interested in knowing how the economy is doing when it makes policy decisions. If economists only tracked the value of the goods being produced in the economy, they might get tricked into thinking things are going better than they are.
For example, if a country’s gross domestic product (the value of all the goods produced inside a country’s borders in a year) increased from $19.4T to $19.6T, it would be tempting to say that the economy was expanding. But if the value of goods being produced increased due to inflation, that might not be the case.
Using this information, Congress may be motivated to increase spending or decrease taxes to stimulate the economy. Likewise, the Federal Reserve may use this information to reduce interest rates to encourage more borrowing.
Second, a large number of government programs and employment contracts use the CPI to adjust payments. This includes Social Security benefits, military and civil service retirement benefits, eligibility for income-based government aid, and federal income tax brackets.
CPI is also used to automatically provide cost-of-living wage increases for millions of workers. Because inflation pushes up the prices of things everyone buys, getting the same goods will cost more money. If people’s incomes don’t rise to offset the growth in prices, they won’t be able to afford the same standard of living. That has the same effect as a pay cut. For this reason, many long-term contract negotiations tend to have a cost-of-living adjustment to account for inflation.
Employees at the Bureau of Labor Statistics regularly check the prices of a predetermined selection of things people purchase, broken into eight categories:
The CPI’s market basket is made up of roughly 80,000 items each month from these categories, weighted to mimic the buying patterns of an average American household. This basket can represent how prices change for only wage earners (Consumer Price Index for wage earners and clerical workers, called CPI-W), or it can include all urban consumers (CPI-U). The data can also be specific to a certain metropolitan area, in which case the BLS only uses prices from stores in the target area.
The Consumer Price Index is the most commonly cited measure of inflation, but it’s not the only one. One alternative measure is the Producer Price Index (PPI). Rather than looking at how the price of consumer goods is changing, this index measures wholesale prices over time.
Another alternative inflation measure is called the GDP deflator. It measures the change in the price of all new goods and services produced domestically in an economy. This method is different than the CPI, which uses a basket of products as a representative sample of the goods being purchased.
Finally, the Bureau of Economic Analysis publishes a separate measure of inflation called the Personal Consumption Expenditure Price Index. This is based on monthly consumer surveys about household spending on goods and services.
According to the Bureau of Labor Statistics, the consumer price index for 2019 was:
The CPI for 2019 is the average of the monthly values. So far, it has averaged 255.677. In 2018 the average CPI was 251.107, implying that inflation in 2019 is on track to be 1.8% ((255.667-251.107)/251.107)*100.
What is a Ceteris Paribus?
Ceteris paribus, or “all else equal,” is a concept used by economists to make assumptions about the relationship between two specific variables — If they disregard all other possible economic variables.
What is a Sunk Cost?
A sunk cost refers to money a company has already spent and that they won’t be able to recover.
What is Consignment?
Consignment is a business relationship where one party agrees to sell an item on behalf of another party for a fee.
What is a Hedge?
A hedge in investing is the practice of offsetting potential losses in one asset with potential gains in another investment — importantly, a hedge should generally be expected to see its price move not in tandem with the asset being hedged.
What is Adverse Selection?
Adverse selection occurs when incomplete information leads you to pay or charge an amount that doesn't match an undisclosed risk.