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The consumer price index (CPI) measures the change in prices in a weighted basket of goods and services over time. The CPI is one of the most common measures of inflation, and when the media, investors, economists and others talk about inflation, they usually refer to the CPI.
Here’s what you need to know about the CPI, how it’s calculated and its potential impact on you.
What is the consumer price index and how does it work?
The CPI tracks changes in the costs of a package of products and services over a certain period of time. This basket, which is representative of the spending habits of the majority of urban consumers, includes a wide range of items, from food and medical care to transportation services.
By recording price changes for each item in this basket, the CPI serves as a reliable measure of inflation or deflation. In other words, it provides a snapshot of how much it costs for consumers to maintain their standard of living and acts as an important tool for identifying periods of economic inflation or deflation.
The monthly CPI report contains two important inflation figures:
- Price changes per month: This figure shows how prices have changed compared to the previous month’s prices. So, for example, this aspect of a report shows how March prices changed compared to February prices.
- Price changes per year: This figure shows how prices have changed compared to the same month in the previous year. For example, a report can show how June 2024 prices compare to June 2023 prices.
In general, most people use the year-over-year rate when talking about inflation. This annualized number provides more context when thinking about pricing, and provides an entire year’s worth of comparison, as opposed to a month-to-month comparison, which may show more “noise.”
“Americans who notice higher egg or gasoline prices from one week to the next may be quick to blame inflation, but the wallet-damaging kind that Fed officials fear most won’t happen. happen overnight,” said Sarah Foster, president of Bankrate. reporter on the American economy. “Economists and the Fed are looking forward to broad, sustainable price growth that will take time to build.”
Here is a recent snapshot of the CPI and figures from a year ago.
What does the Consumer Price Index (CPI) include?
The CPI is calculated based on the prices of tens of thousands of different goods and services. The U.S. Bureau of Labor Statistics (BLS) classifies expenses into more than 200 categories, which are divided into eight major groups.
- Food and drink
- Housing
- Clothing
- Transport
- Medical care
- Recreation
- Education and communication
- Other goods and services
For each of these categories, the CPI data takes a deep dive into prices. For example, in the food and beverage category, the index tracks individual prices, such as for flour, cereals, rice, pasta, cakes, beef, pork, milk and many more items.
The CPI also includes various user fees charged by the government, such as for water and sewerage, car registration and vehicle tolls, as well as sales and excise taxes related to the prices of specific goods and services.
However, it does not include income taxes and social security taxes, which do not cover purchases of consumer goods and services. It also does not include investments such as stocks, real estate, bonds and life insurance, which are not everyday consumption expenses.
How are prices collected for the CPI?
Collecting prices for the CPI is a painstaking process. Each month, the BLS collects data from approximately 23,000 retail and service businesses, along with rental data from thousands of landlords or tenants, yielding approximately 94,000 price quotes.
Price data is collected across three price periods in 75 metropolitan areas throughout the month, ensuring comprehensive price coverage. This methodology allows the CPI to measure the change in prices for a market basket of frequently purchased goods and services.
Despite its critical role, CPI has limitations, such as not capturing the inflation experiences of rural populations or different demographic subgroups, and potential substitution biases, which may exaggerate changes in the cost of living.
How does the CPI calculation work?
The annual CPI is calculated by dividing the value of the basket of goods today by the value of a year ago and multiplying by 100. This formula determines the overall inflation rate, that is, the percentage change in the CPI over a given period.
In January 2024, the CPI rose 3.1 percent from the previous twelve months, before seasonal adjustments.
What are the different types of CPI?
While analysts often talk about “the” CPI they mean the CPI for all urban consumers (CPI-U), but several other types of CPI also exist. These other versions of the CPI reflect different price trends depending on the reweighting of the basket of goods and services.
The BLS publishes two main types of CPIs every month.
- The Consumer Price Index for All Urban Consumers (CPI-U), which covers approximately 93 percent of the U.S. population, excluding those living in remote rural areas, farm households, institutions, or on military bases. The CPI-U is the most frequently mentioned index when it comes to changes in consumer prices.
- The Consumer Price Index for Urban Wage Earners and White-collar Workers (CPI-W), covers approximately 29 percent of the U.S. population. This index is primarily used to adjust Social Security benefits and other federal benefits, as well as to shift federal income tax brackets to prevent tax brackets from rising due to inflation.
But other price indexes are calculated based on prices from the basic CPI-U:
- Chained consumer price index for all urban consumers (C-CPI-U): Known as the chained CPI, this index uses more up-to-date weights for price data and models consumer spending behavior in response to price changes (for example, consumers switching to a cheaper product when its price becomes relatively cheaper).
- Consumer Price Index for Americans 62 and older (R-CPI-E): This index reweights prices based on the CPI-U data to track spending by households with at least one consumer aged 62 or older.
- Core CPI: This inflation measure starts with the CPI-U and then strips out food and energy prices due to their more volatile nature. The goal is to eliminate ‘noisy’ data to get a clearer picture of inflation’s underlying trends.
Additionally, the BLS can break down the data based on several factors, including:
- Geographyfor example, by looking only at a city or region of the country
- A specific subset of pricing datasuch as rents, food or the popular core CPI, which excludes food and energy prices
- Time periodwith data going back decades
Another popular monthly inflation gauge is the Personal Consumption Expenditures (PCE) index. This index is tracked and managed by the U.S. Bureau of Economic Analysis (BEA).
What impact does the CPI have on the economy and consumers?
The CPI serves as a crucial tool for policymakers, financial markets, companies and consumers. By keeping a close eye on it, they can assess the state of the economy and make informed decisions. Inflation affects the purchasing power of money and drives economic policy decisions, such as interest rate decisions by the Federal Reserve.
“Inflation data can be likened to a compass that guides Federal Reserve officials in deciding whether to raise rates and by how much,” says Foster. “But inflation data is also more important to everyday Americans than they might think, from the retirees who rely on fixed incomes to the Americans hoping to ensure their wages keep pace with rising prices.”
Investors pay close attention to CPI data to understand how the Federal Reserve might act and whether it might adjust interest rates in response to prevailing price trends. Potential home buyers will then want to pay attention to inflation data, because this can affect their mortgage interest rate.
Additionally, the CPI influences adjustments to government benefits, such as Social Security benefits and federal tax brackets, to account for changes in the cost of living. Companies also use CPI data to inform pay increase decisions and ensure salaries keep pace with inflation. The IRS uses the CPI to guide decisions about tax deductions and other indexed amounts.
The CPI is also important for contracts with escalation agreements related to price increases. These contracts include union contracts, annual escalator leases, inflation-protected insurance policies, alimony, and child support payments.
In short
The CPI looks at how prices for a basket of goods and services change over time to measure how prices are changing. The CPI is the most commonly cited inflation measure and is used by consumers, economists, policymakers and others in their economic decisions.
