The consumer price index (CPI) is considered one of the most fundamental and critically important economic indicators used to measure inflation. A CPI is used 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. Unexpectedly high or low numbers can wreak investment havoc. The U.S. Bureau of Labor Statistics (BLS) releases several different consumer price indexes on a monthly basis, including the CPI.
Despite being widely used as the core indicator of inflation, the CPI is far from perfect as a measure of either inflation or the cost of living. It has a number of inherent weaknesses. Its accuracy 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.
Here, we take a look at some of the limitations of the CPI and why this controversy persists.
- The consumer price index, or CPI, is a widely used measure of inflation, but it has come under fire as being less than ideal.
- The U.S. Bureau of Labor Statistics publishes the CPI every month, along with other economic metrics.
- The CPI tracks the average price of a basket of goods, including basic foodstuffs, housing costs, clothing, healthcare, and recreational items.
- However, it does not account for qualitative changes or substitutions of similar goods.
- In addition, the CPI focuses on urban consumers and places less emphasis on the costs for people in rural areas.
The CPI Basket
The CPI is a weighted index of goods purchased by consumers.
It may constitute a relatively good measure of price changes in the specific goods in its basket. However, one limitation of the CPI is that the consumer goods it considers do not represent all production or consumption in the economy. Therefore, as a basic economic barometer, the CPI is inherently flawed.
Currently, the basket of goods includes basic food and beverages such as cereal, milk, and coffee. It also includes housing costs, bedroom furniture, apparel, transportation expenses, medical care costs, recreational expenses, and toys. The cost of admissions to museums also qualifies for inclusion.
Education and communication expenses are included in the basket's contents, as well. The government also takes note of other, seemingly random items such as tobacco, haircuts, and funerals.
Still, the goods in the basket are only a sampling of the universe of goods and services available to consumers. As a result, the CPI may have some blind spots.
The Consumer Price Index increased a seasonally adjusted 1.0% in May 2022 after rising 0.3 percent in April. The full index increased a not seasonally adjusted 8.6% over the past 12 months.
One problem with the CPI that's been identified by economists, and which the Bureau of Labor Statistics freely admits, is that the index does not factor in the effects of substitution.
The economic reality is that when certain goods become significantly more expensive, many consumers buy less expensive alternatives. For instance, they may buy the store brand instead of the name brand. Or they may buy regular gasoline instead of premium grade.
The CPI can't take this common practice into account. Instead, it presents numbers that assume consumers are continuing to buy the same amount of increasingly expensive goods.
Improvements in Product Quality
Novelty and innovation represent another weakness in the CPI. Products aren't included in the CPI's basket of goods until they're seen over time to be staple consumer purchases. So, even though new products may represent considerable consumer expenditures, they may not yet be included in the calculation of the CPI.
Any pure price index is flawed by the fact that 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.
However, 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.
Focus on Urban Consumption
The CPI is constructed to focus on the buying habits of urban consumers. It has often been criticized as not providing an accurate measure of either the prices of goods or the consumer buying habits of more suburban or rural areas.
While cities are indeed the most important areas of economic production, a large swath of the nation's population still lives outside of metropolitan areas, where prices may be higher.
A broader critique is that the CPI does not provide separate reports on different demographic groups.
Hidden inflation refers to expenses that are not reflected in explicit price increases. One of the most common forms of hidden inflation is shrinkflation. Shrinkflation occurs when companies cut costs by offering a smaller product at the same price. Customers end up essentially spending more money as they spend the same amounts on less product.
Hidden inflation can also be reflected in qualitative changes that are difficult to track with the CPI. For example, companies may choose to cut corners on their assembly lines to produce less durable goods. Or they may introduce preservatives to extend the shelf-life of what was previously sold as fresh produce.
These changes may introduce unnoticed increases to the cost of living that are not reflected in the CPI.
Who Issues the Consumer Price Index?
The Bureau of Labor Statistics uses information gathered by BLS data collectors to calculate the CPI. Then, it publishes the CPI on a monthly (and sometimes bimonthly) basis.
Are There Inflation Indexes Other Than CPI?
Yes. The Bureau of Labor Statistics issues a variety of inflation gauges, including the Producer Price Index (PPI), which measures inflation during the production process, the Employment Cost Index (ECI), which measures inflation in the labor market, the International Price Program (IPP), which measures inflation for imports and exports, and more.
What Inflation Gauge Does the Federal Reserve Watch?
For its monetary policy responsibilities, the Fed watches the core Personal Consumption Expenditures Price Index (PCE) more closely than the CPI. It's a measure of inflation issued by the Bureau of Economic Analysis.
The Bottom Line
Despite its drawbacks, the CPI is still widely used. It provides the basis for annual cost of living adjustments to Social Security payments and other government-funded programs. That probably won't change any time soon. Yet, it's important to recognize and be aware of the CPI's limitations.
Over the years, the basket methodology used to calculate the CPI has undergone several revisions. According to the BLS, the changes have tried to remove or reduce biases that caused the CPI to overstate the inflation rate. Still, as long as the CPI is used to track inflation officially, controversy will remain.