A:

The consumer price index, or CPI, is considered one of the most fundamental and critically important economic indicators, not only in the United States but in virtually every other developed nation as well. The release of monthly CPI numbers almost invariably has a significant impact on the financial markets, and unexpectedly high or low numbers often wreak investment havoc. But despite the CPI being followed so relentlessly , the index is far from perfect as a measure of either inflation or the cost of living, and it has a number of inherent weaknesses.

The CPI is a weighted index of goods purchased by consumers. While it may constitute a relatively good measure of price changes in the specific goods purchased in its "basket," a limitation of the CPI is that the consumer goods it considers do not provide an index that measures all production or consumption in the economy. Therefore, as a basic economic barometer, the CPI is inherently flawed.

Even the Bureau of Labor Statistics (BLS) that produces the CPI freely admits that the index does not factor in substitution. The economic reality is that when certain goods become significantly more expensive, many consumers find less expensive substitutes. The CPI does not take this common consumer practice into account but instead presents numbers assuming consumers are continuing to buy the same amount of increasingly expensive goods.

New products represent another weakness in the CPI. Products do not become included in the CPI's basket of goods purchased until they become virtually staple purchases by consumers. So even though new products may be widely purchased and represent considerable consumer expenditures, they may still be years away from possible inclusion in the calculation of the CPI.

Although the CPI is widely used as the core indicator of inflation, its accuracy in this area has drawn increasing criticism. For example, during a period when energy costs rose by more than 50% and the prices of some of the most commonly purchased grocery items increased by nearly 30%, the CPI continued to show a very modest inflation rate when other indicators measuring the buying power of consumers showed a dramatic increase in the cost of living.

Because the CPI is purposely constructed with a focus on the buying habits of urban consumers, it has often been criticized as not providing an accurate measure of either prices of goods or consumer buying habits for more rural areas. The CPI also does not provide separate reports according to different demographic groups.

Any pure price index is flawed by the fact it does not factor in changes in the quality of goods purchased. Consumers may gain a net benefit from purchasing a product that has risen in price as a result of significant improvements in the quality of the product and the purposes it serves. But the CPI has no standard for measuring such quality improvements and therefore reflects only the increase in price without any appreciation for additional benefits to consumers.

It is important to recognize limitations in the CPI because of its wide use. For example, it provides the basis for annual cost of living adjustments to Social Security payments and other government-funded programs.

RELATED FAQS
  1. Is the consumer price index (CPI) a cost of living index?

    Explore the consumer price index (CPI) and understand why it is not an actual cost of living index although it is often identified ... Read Answer >>
  2. How are taxes treated in the consumer price index (CPI)?

    Discover how various taxes are treated, either included or excluded, in the Consumer Price Index, or CPI, and how this affects ... Read Answer >>
  3. Which economic factors most affect the demand for consumer goods?

    Understand how key economic factors such as inflation, unemployment, interest rates and consumer confidence affect the level ... Read Answer >>
  4. How is the basket of goods selected for the Consumer Price Index?

    Read about alterations in the market basket for the consumer price index, a measure of approximate consumer price changes ... Read Answer >>
  5. Is the consumer price index (CPI) the best measure of inflation?

    Discover how the CPI is one of the most used indexes to measure inflation, but due to its limitations, the PPI and GDP deflator ... Read Answer >>
  6. Can the consumer price index (CPI) for individual areas be used to compare living ...

    Understand why the Consumer Price Index, or CPI, cannot appropriately be used for comparing the cost of living across different ... Read Answer >>
Related Articles
  1. Trading

    4 Key Indicators That Move The Markets

    Find out what reports to watch in order to anticipate and react to market movements.
  2. Insights

    Why The Consumer Price Index Is Controversial

    Find out why economists are torn about how to calculate inflation.
  3. Investing

    Deadly Flaws In Major Market Indicators

    These indicators give investors and experts some data to work with, but they're far from perfect measures.
  4. Insights

    The Consumer Price Index: A Friend To Investors

    As a measure of inflation, this index can help you make key financial decisions.
  5. Insights

    The Consumer Price Index

    Find out how this economic measure can help you make key financial decisions.
  6. Insights

    What Does Price Level Mean?

    Price level is the average of all current prices for goods and services in an economy.
  7. Investing

    Mattel Stock: 4 Things to Watch (MAT)

    Here are the four leading economic indicators that could affect shares of Mattel Inc. in the next six months, but which ones will have the most impact?
  8. Investing

    Rising Prices: Inflation or Quality Improvements?

    Price indices are used to measure inflation, but qualitative improvements in products complicates attempts to isolate the true cause of rising prices.
RELATED TERMS
  1. Basket Of Goods

    A relatively fixed set of consumer products and services valued ...
  2. Market Basket

    A subset of products or securities that is designed to mimic ...
  3. Consumer Goods

    Products that are purchased for consumption by the average consumer. ...
  4. Consumer Price Index - CPI

    A measure that examines the weighted average of prices of a basket ...
  5. Convenience Good

    A consumer item that is widely-available, purchased frequently ...
  6. Private Good

    A product that must be purchased in order to be consumed, and ...
Hot Definitions
  1. Leveraged Buyout - LBO

    The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. ...
  2. Current Assets

    A balance sheet account that represents the value of all assets that can reasonably expected to be converted into cash within ...
  3. Tax Liability

    The total amount of tax that an entity is legally obligated to pay to an authority as the result of the occurrence of a taxable ...
  4. Preferred Stock

    A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares ...
  5. Net Profit Margin

    Net Margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage ...
  6. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
Trading Center