The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by consumers in urban households for a basket of goods and services. These goods and services are broken into eight major groups: food and beverages, housing, apparel, transportation, medical care, recreation, education, and communication.
The CPI is calculated by taking price changes for each item in the predetermined basket of consumer goods and services and then averaging them. Changes in the CPI reflect changes in the cost of living in the U.S. As such, the CPI is an economic indicator most frequently used for identifying periods of inflation (or deflation) in the U.S.
However, some economists question whether the CPI is the best measure of inflation. For several years, there has been some controversy about whether the CPI overstates or understates inflation, how it is measured, and whether it is an appropriate proxy for inflation. One of the main reasons for this contention is that economists differ on how they believe inflation should be measured.
Here, we cover the CPI (along with some changes made to improve it) as well as some other inflation indices.
- The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by consumers in urban households for a basket of goods and services.
- Changes in the CPI reflect changes in the cost of living in the U.S.
- The CPI is an economic indicator that is most frequently used for identifying periods of inflation (or deflation) in the U.S.
- While the CPI is the most widely watched and used measure of the U.S. inflation rate, many economists differ on how they believe inflation should be measured.
- For a more accurate and comprehensive measure of inflation rates in the U.S., look to the Personal Consumption Expenditures (PCE) Price Index, or use the Producer Price Index (PPI) and the gross domestic product (GDP) deflator in tandem along with the most recently reported CPI measurements.
Consumer Price Index and Overall Price Changes
Inflation is a rise in the general level of prices and is often expressed as a percentage. It results in a unit of currency effectively buying less than it did in prior time periods. When inflation occurs in the U.S., it indicates a decrease in the purchasing power of the dollar.
The U.S. Bureau of Labor Statistics (BLS) reports the CPI on a monthly basis and has calculated it as far back as 1913. It is based upon the index average for the period from 1982 through 1984 (inclusive), which was set to 100. So a CPI reading of 100 means that inflation is back to the level that it was in 1984, while readings of 175 and 225 would indicate a rise in the inflation level of 75% and 125%, respectively. The quoted inflation rate is actually the change in the index from the prior period, whether it is monthly, quarterly, or yearly.
Changes in the CPI reflect price changes in the economy. When there is an upward change in the CPI, this means there has been an increase in the average change in prices over time. This eventually leads to adjustments in the cost of living and income (presumably so that income is adjusted to meet a higher cost of living). This process is referred to as indexation.
While it does measure the variation in price for retail goods and other items paid by consumers, the CPI does not include things like savings and investments, and it can often exclude spending by foreign visitors.
In April 2021, the Consumer Price Index (CPI) increased 0.8% on a seasonally adjusted basis after rising 0.6% in March 2021. Compared to the year prior, the full index increased 4.2%, making it the largest 12-month increase since September 2008.
Consumer Price Index Subcategories
The CPI provides many different subcategories of price indexes. In total, there are indexes for the U.S., the four Census regions, the nine Census divisions, two sizes of city classes, eight cross-classifications of regions and size classes, and for 23 local areas. The BLS publishes CPI data monthly for indexes related to the U.S., the four Census regions, and some local areas.
Indexes are also available for two population groups: the Consumer Price Index for All Urban Consumers (CPI-U), and the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The CPI-U covers approximately 93% of the total population.
- The CPI-U includes professionals, the self-employed, the poor, the unemployed, and the retired—all residing in urban and metropolitan areas.
- The CPI-W is, as mentioned above, for all urban wage earners and clerical workers. This accounts for an additional 29% of the population. This measurement skews more toward active workers and those in the lower social classes.
The current CPI measurements do not take into account the spending habits of those living in rural or nonmetropolitan areas, including farm families. The current CPI measurements also do not take into account members of the armed forces and those in institutions, such as prisons or mental hospitals.
Economists Differ on How Inflation Should Be Measured
While the CPI is the most widely watched and used measure of the U.S. inflation rate, many economists differ on how they believe inflation should be measured. Because the methodology used to calculate the CPI has changed over time—undergoing numerous revisions—some critics of the CPI say that this measurement can be purposely manipulated by the U.S. government. Other economists argue that the CPI’s viability as an indicator of inflation is questionable simply because it may be a lagging indicator. In other words, it may not be very accurate at capturing current levels of inflation.
Over the years, the methodology used to calculate the CPI has undergone numerous revisions. According to the BLS, the changes removed the supposed biases that caused the CPI to overstate the inflation rate in the past. The newer methodology takes into account changes in the quality of goods and substitution. Substitution, the change in purchases by consumers in response to price changes, alters the relative weighting of the goods in the basket.
The BLS also uses additional indexes to measure inflation. The Producer Price Index (PPI) measures the domestic output of raw goods and services. It attempts to account for the fact that, when producers face input inflation, the increases in their production costs are passed on to retailers and consumers. Hence, the PPI is a more accurate measure of a country’s economic output because it is not affected by consumer demand.
Gross Domestic Product (GDP) Deflator
The U.S. Bureau of Economic Analysis (BEA) uses the gross domestic product (GDP) deflator (also known as the GDP price deflator) as an additional indicator of the level of U.S. inflation. The GDP deflator measures the aggregate prices of all goods and services produced by the entire nation; it encompasses both the CPI and PPI statistics.
The CPI, which measures the level of retail prices of goods and services at a specific point in time, is one of the most commonly used inflation measures because it reflects changes to a consumer’s cost of living. However, all calculations based on the CPI are direct, meaning that the index is computed using prices of goods and services already included in the index.
The fixed basket used in CPI calculations is static and sometimes misses changes in prices of goods outside of the basket of goods. Since GDP isn’t based on a fixed basket of goods and services, the GDP deflator has an advantage over the CPI. For instance, changes in consumption patterns or the introduction of new goods and services are automatically reflected in the GDP deflator but not in the CPI.
GDP represents the total output of goods and services. However, as GDP rises and falls, the metric doesn’t factor the impact of inflation or rising prices into its results. The GDP deflator addresses this by showing the effect of price changes on GDP, first by establishing a base year and, second, by comparing current prices to prices in the base year.
Simply put, the GDP deflator shows how much a change in GDP relies on changes in the price level. It expresses the extent of price level changes, or inflation, within the economy by tracking the prices paid by businesses, the government, and consumers.
What this means is that the GDP price deflator captures any changes in an economy’s consumption or investment patterns. That said, trends observed in the GDP price deflator are usually similar to the trends seen in the CPI.
For a more accurate and comprehensive measure of U.S. inflation rates, the Producer Price Index (PPI) and the gross domestic product (GDP) deflator can be assessed in tandem with the most recently reported Consumer Price Index (CPI) measurements.
Personal Consumption Expenditures (PCE) Price Index
Personal consumption expenditures (PCEs) are another measure of imputed household expenditures and how those costs change over time. PCEs are summarized in the Personal Consumption Expenditures Price Index, which is released monthly by the BEA and measures price changes in consumer goods and services exchanged in the U.S. economy.
In 2012, the PCE Price Index became the primary inflation index used by the U.S. Federal Reserve when making monetary policy decisions. It is used instead of the CPI because the PCE Price Index is composed of a broad range of expenditures that exceeds the limited basket of goods used in the CPI. The PCE Price Index is also weighted by data acquired through business surveys, which tend to be more reliable than the consumer surveys used by the CPI.
Another difference between the PCE Price Index and the CPI is that the PCE Price Index uses a formula that allows for changes in consumer behavior and changes that occur in the short term. These adjustments are not made in the CPI formula.
These factors result in an arguably more comprehensive metric for measuring inflation by using the PCE Price Index.