What to know about the Consumer Price Index - a key economic indicator that measures inflation

• The Consumer Price Index (CPI) measures inflation by comparing the average change in price over time for a basket of consumer goods and services.
• The CPI is an important economic indicator that not only illustrates the effectiveness of government economic policy but influences financial decision-making throughout the economy.
• While the CPI is widely used, it is more representative of urban populations while excluding rural populations and some geographic regions.

Inflation is a word that's in the news frequently, and it's a word that makes people nervous. When prices for goods like food, clothing, and gasoline are on the rise, consumers fear that the purchasing power of their dollars is declining.

Inflation is an unavoidable part of economic growth, but it can be measured and managed to maintain a healthy economy. This is why it's important to understand what the Consumer Price Index is and how it ties into inflation.

What is the Consumer Price Index?

The Consumer Price Index (CPI) measures the average change in prices that urban consumers pay for "a market basket" of goods and services over a specified period. This market basket includes food products like cereal, milk, and coffee, housing costs, gasoline, clothing, medical care, communications services, personal care services, transportation costs, and more.

It's widely used to help businesses project expenses and budget, while investors use the information to determine required returns and inform investment decisions. It also provides a barometer to aid the government in managing the economy. Changes in the CPI affect almost everyone in one way or another.

The CPI market data is developed from expense information collected from the Consumer Expenditure Survey (CE) program that's sent out on a quarterly basis. It's a national survey conducted by the US Census Bureau on behalf of the BLS and collects data needed for the calculation of the CPI. It's been around since 1980.

Note: There are two separate surveys in the Consumer Expenditure survey: the quarterly interview survey and the diary survey. The quarterly interview asks household respondents about the costs of large purchases (car, house) and regular expenses (rent, utilities). The diary survey asks survey respondents to keep two one-week diaries recording all purchases to capture small purchases like food, meals, and gasoline.

Understanding how CPI works

The CPI uses the average price changes for an established basket of goods and services to demonstrate price trends within the economy. An increase in the value of the index offers a quantitative measure of inflation, or the decline of the dollar's purchasing power over time. Aside from eroding consumer purchasing power, inflation can be very worrying because it means that savings will be worth less in the future.

When the CPI index value declines, consumer prices are falling over time and the purchasing power of the dollar is increasing. This is known as deflation. While falling prices sound like a good thing, deflation can indicate an impending recession.

The Bureau of Labor Statistics (BLS) reports the CPI on a monthly basis, and also breaks down CPI by region. CPI is calculated for the Northeast, Midwest, South, and West, as well as the New York, Chicago, and Los Angeles metropolitan areas.

"The CPI is important to the average person as it makes it possible to compare the increase in the average price level to the increase in wages," says Dr. Peter Westin, adjunct professor of finance at DePaul University and founder of Stratonomics. "If consumer price inflation exceeds the increase in the average wage, real wages are declining." Consumers can clearly see the impact of inflation on the purchasing power of the dollars they earn.

Quick tip: By following the CPI, consumers can understand how inflation is impacting their purchasing power and make financial decisions accordingly.

How is the CPI used?

Because of the many ways the CPI is used, it affects almost every American. It is used as:

• An economic indicator. As the most widely used measure of inflation, the CPI can indicate the effectiveness of government economic policy. It serves as a guide for business, labor, and individuals, as well as for the government, in making economic decisions. It influences price changes for inflation sensitive assets, like commodities and bonds. Importantly, the President, Congress, and the Federal Reserve Board depend on trends in the CPI to establish fiscal and monetary policies.
• A basis for adjusting dollar values. Many different types of payments are adjusted based on changes in the CPI. For example, it impacts Social Security payments, benefits through government assistance programs, and government pensions. It's incorporated into the federal tax structure to prevent inflation-related increases in tax rates. It's even used to adjust the cost of school lunches. Significantly, it also impacts wages and salaries through cost-of-living (COLA) adjustments to ensure that wage levels keep pace with inflation.
• A deflator of other economic series. The CPI is used to adjust other economic series such as retail sales, hourly and weekly earnings, and others. It's applied to translate indexes into inflation-free, or real, terms.

Quick tip: The CPI is one of the most watched among economic indicators and can influence everything from wages and salaries to social security and government benefits. It can even portend changes in economic policy.

The limitations of CPI

While the CPI is one of the most important and widely used economic indicators, it has certain limitations.

Limit in measurement: Sampling errors. There is continuing controversy as to whether the CPI overstates or understates inflation. Since the CPI calculation is based on a sample of items, it cannot replicate the result that would be achieved by using all retail purchases by the entire index population. This sampling error limits accuracy. The methodology also fails to account for personal spending habits, new products, product substitutes and product quality - all of which may have an impact on price levels that aren't related to inflation.

Limit in measurement: Non-sampling errors. Non-sampling errors can arise even when there are no mistakes made. This type of error occurs because a sample doesn't necessarily match the entire data universe from which it's taken. In regard to CPI, these errors can arise from issues in collecting price data, lags in conducting surveys, difficulty in defining basic concepts, and addressing quality change. These errors can cause persistent bias in results, so the BLS expends considerable effort to identify errors and improve the accuracy of the index.

Limited applications. The CPI also considers only urban consumers, thus excluding large swathes of the population from consideration and leaving many regions and demographics unrepresented in the calculation. Rural consumers, for example, will have different spending habits from urban consumers, and they will also make different types of expenditures. Furthermore, since the CPI is based on only consumer goods, it does not represent the entirety of production and consumption in the country.

How to calculate CPI

The CPI calculation begins with the cost of the market basket of goods in the year for which you would like to calculate the CPI. Divide this value by the cost of the same basket in a specified base year. That is the year from which the calculation period begins.

For example, assume that the basket cost was $1,500 in the base year. The base year index value is 100. For the sake of the example, assume the base year is 2019.

In 2020, the cost of the basket of goods rose to $1,550.

$1,550/1,500 = 1.0333 x 100

1.0333 X 100 = 103.3, which is the CPI for 2020.

To determine the percentage rate of inflation, subtract 1 from the quotient, or (1.0333 - 1) or 0.0333

Multiply 0.0333 by 100 to arrive at the annual inflation rate, expressed by percentage, which is 3.33%

Quick tip: You can read Bureau's publications such as the Monthly Labor Review and Beyond the Numbers if you want to get more information on the CPI.

The different types of CPI

Two types of CPI are calculated in order to provide a more comprehensive level of data on inflation.

• CPI-W is calculated for Urban Wage Earners and Clerical Workers. It is based on households in which income is more than 50% derived from clerical or wage occupations. The BLS estimates that this incorporates around 30% of the population.
• CPI-U is calculated for All Urban Consumers and incorporates more than 70 percent of the population. It offers a more representative view of the overall population and is consequently more widely used.

Each type is also broken down into more granular representations based on Census regions and city size.

Quick tip: While there are two types of CPI, the index calculated for urban consumers is the most comprehensive, applying to more than 70% of the population. However, rural populations, as well as some geographic regions, are not well represented.

CPI and investing

The CPI is important to investors for many reasons, as the rate of inflation can have an impact across financial markets. Rising inflation rates can have a negative impact on bond values, and it's very damaging to those who receive pensions or annuity payments. Rising inflation also impacts the stock market. When inflation rises beyond a comfortable level (2%, as a rule of thumb), the Fed may take steps such as raising interest rates to slow the economy. Operating a company in a rising rate environment becomes more expensive, earnings decline, and stock prices fall. However, stock performance by sector may vary.

"Investors will be concerned about inflationary expectations more than the current inflation level," says Dr. Westin. "For example, if the outlook for inflation deteriorates, investors may want to reposition their portfolio in order to take advantage of inflation."

Historically, energy, real estate, and consumer staples have tended to outperform in periods of higher inflation while tech stocks and materials have tended to underperform. However, and most importantly, investors are closely monitoring the forecast for CPI as an indicator of actions that may be taken by the Federal Reserve.

The inflation outlook is also an important consideration for investors in establishing a required rate of return. Since inflation reduces the purchasing power of money over time, desired investment returns must take this into account. The longer an investor's time horizon, the more important the inflation outlook becomes.

The return an investor receives on an investment or portfolio is the nominal return. However, this rate of return is not adjusted for inflation. By using CPI inflation rates, this return can be adjusted to take inflation into account, yielding the real rate of return. An investor's required return should always be the real rate of return to account for the negative impact of inflation on investment values.

The financial takeaway

The Consumer Price Index has significant influence over many aspects of a person's financial life. If you're looking for a new job or trying to negotiate a salary increase, it's important to know the inflation rate. Asking for an annual cost-of-living increase based on the CPI will make sure your purchasing power doesn't decline.

Retirement investors should also keep the CPI-based inflation rate in mind as they plan for the future. Not only does it impact the required rate of return on retirement savings, but it's a necessary component in estimating income needs in retirement. Indeed, the inflation rate is an important component in any type of financial planning.

An inflation outlook can also aid in other financial decision making, for example buying a house. If inflation is rising, interest rates can also be expected to rise and it might be wise to lock in a mortgage while rates are low. Keeping an eye on the CPI can help you make better financial decisions as you prepare for the future.

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