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A country's 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," one limitation of the CPI is that the consumer goods it considers do not provide a sampling that represents all production or consumption in the economy. Therefore, as a basic economic barometer, the CPI is inherently flawed.

Another problem, which even the Bureau of Labor Statistics (producer of the CPI) freely admits, is 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 alternatives to them. Unable to take this common practice into account, the CPI instead presents numbers assuming consumers are continuing to buy the same amount of increasingly expensive goods.

Novelty and innovation represent another weakness in the CPI. Products do not become included in the CPI's basket of goods until they become virtual staple purchases by consumers. So even though new products may 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. In contrast, 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 advantages to consumers.

Despite its drawbacks, the CPI is widely used: It provides the basis for annual cost of living adjustments to Social Security payments and other government-funded programs, for example. That probably won't change soon, but it's important to recognize be aware of its limitations.

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