Consumer Price Index
Consumer price index (CPI) is a price index that measures the average change over time in the prices paid by consumers for a weighted average market basket of consumer goods and services purchased by households. It is one of the most closely watched national economic statistics and is the most widely used measure of inflation in many countries. Changes in the CPI track changes in the general price level and are used to calculate the inflation rate.[1]
The CPI is constructed by national statistical agencies, such as the U.S. Bureau of Labor Statistics (BLS), and is typically published monthly or quarterly. The annual percentage change in the CPI is used as a measure of inflation and is a key input for monetary policy, wage and pension indexation, and economic analysis.[2]
Definition
A CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically. Sub-indices and sub-sub-indices can be computed for different categories and sub-categories of goods and services, which are combined to produce the overall index with weights reflecting their shares in the total consumer expenditure covered by the index.[1]
The index compares the cost of purchasing a fixed market basket of goods and services in a given period with the cost of purchasing the same basket in a base period. The basket is updated periodically to reflect changes in consumer spending habits. The prices of the items in the basket are collected from a sample of retail and service establishments and then adjusted for changes in quality or features.[1]
Calculation
The CPI is usually computed as a weighted average of sub-indices for different components of consumer expenditure, such as food, housing, and clothing, each of which is itself a weighted average of sub-sub-indices. The general relationship can be expressed as:
- CPI = Σ (Item weight × Item price change)
Indices are computed by comparing prices each month with prices in a price-reference month. The weights used to combine them into higher-level aggregates relate to the estimated expenditures of the consumers covered during the preceding whole year. The index is therefore a fixed-weight index, though rarely a true Laspeyres index, because the weight-reference period and the price-reference period usually do not coincide.[1]
The inflation rate is calculated from the percentage change in the CPI. For example, if the CPI in one month is 120 and in the same month of the previous year it was 115, the annual inflation rate is approximately:
- ((120 − 115) ÷ 115) × 100 ≈ 4.3%
Index values are normalised to equal 100 in a chosen base period (for example, 1982–84 for most U.S. indexes). A CPI value of 300 means that the overall price level has tripled since the base period. Percent changes in the index are estimates of the percent change in the price level over the period in question; the 12-month percent change is the most frequently cited figure.[2]
Structure and classification
The CPI has both an item structure and a geographic structure. Items of expenditure are classified into more than 200 categories, arranged into eight major groups. The main groups are:
| Major group | Examples of categories |
|---|---|
| Food and beverages | Breakfast cereal, milk, coffee, chicken, wine, full-service meals, snacks |
| Housing | Rent of primary residence, owners' equivalent rent, utilities, bedroom furniture |
| Apparel | Men's shirts and sweaters, women's dresses, baby clothes, shoes, jewellery |
| Transportation | New vehicles, airline fares, gasoline, motor vehicle insurance |
| Medical care | Prescription drugs, medical equipment, physicians' services, hospital services |
| Recreation | Televisions, toys, pets, sports equipment, museum admissions |
| Education and communication | College tuition, postage, telephone services, computer software |
| Other goods and services | Tobacco products, haircuts, personal services, funeral expenses |
For analytical purposes, the CPI is often divided into food, energy, and all items less food and energy. The last of these receives considerable attention as a measure of underlying core inflation, which is not subject to the volatile movements of food and energy prices.[2]
Types
Several variants of the CPI are commonly reported:
- Headline CPI — the standard index covering all items, including food and energy, which are more volatile.
- Core CPI — excludes food and energy to provide a more stable picture of the underlying trend in inflation.
- Derived CPI — a version in which the effect of changes in indirect taxes (such as value-added tax and excise duties) has been filtered out.
- Based on population coverage, some countries report a CPI for all urban consumers (which covers the majority of the population, including professionals, the self-employed, the unemployed, and retirees) and a CPI for urban wage earners and clerical workers (used to calculate cost-of-living adjustments for benefits and union contracts).[2][3]
Uses
The CPI is a key economic indicator used in many official and private contexts:
- Measuring inflation — the annual percentage change in the CPI is the most commonly cited measure of inflation.
- Indexation — adjusting the real value of wages, salaries, and pensions for the effect of inflation. Many government benefits, such as Social Security payments, are adjusted annually using CPI data.
- Monetary policy — central banks, such as the Federal Reserve, closely monitor CPI data when deciding whether to raise, lower, or hold interest rates.
- Deflation of monetary magnitudes — converting nominal values into real values to show changes in real terms.
- Inflation-protected securities — the principal of investments such as Treasury Inflation-Protected Securities (TIPS) is adjusted based on the CPI.
- Regulation of prices and adjustment of rent and other contracts.[1][3]
Limitations and criticisms
Although the CPI is the most widely used measure of consumer inflation, it is not a perfect measure of the cost of living. Its well-known limitations include:
- Substitution bias — the CPI uses a fixed basket of goods; if the price of beef rises sharply, consumers may switch to chicken, but the index continues to measure beef prices. This can overstate the actual change in the cost of living.
- Quality changes — a new product may cost more than an older model but also offer better features. Adjusting for quality improvements is difficult, and some argue that the CPI overstates inflation by not fully accounting for them.
- Geographic and demographic differences — the CPI is a national average; inflation in a large city may differ substantially from inflation in a rural area, and the spending patterns of different household types vary.
- Coverage limitations — consumers' expenditure abroad is usually excluded, and certain groups, such as the very rich or the very poor, may be excluded. Savings and investment are always excluded.
- Averages that may not reflect individual experience — because it is an average, the CPI may not perfectly reflect any individual's experience of price changes.[1][3]
Related measures
The CPI is one of several price indices. The producer price index (PPI) measures the average change in prices received by domestic producers, rather than by consumers, for their output. The GDP deflator is a broader index that covers all domestically produced goods and services, including investment and government spending. The personal consumption expenditures price index (PCE) is another widely followed measure of consumer inflation, and the Federal Reserve often prefers the core PCE deflator as its gauge of underlying inflation.[1]