The Bureau of Labor Statistics (BLS) computes the CPI by taking the average weighted cost of a basket of goods in a given month and dividing it by the weighted cost of the same basket the previous month. It then multiplies this percentage by 100 to get the number for the index. The equation works like this:
Alternate Name: CPI for All Urban Consumers (CPI-U)Acronym: CPI
How the CPI Works
The Consumer Price Index represents the prices of a cross-section of goods and services commonly bought by urban households. This cross-section represents around 93% of the U.S. population, and it factors in a sample of 14,500 families and 80,000 consumer prices. Housing (called “shelter” by the BLS) is the highest weighted category within the CPI calculation. Shelter uses the concept of “owner’s equivalent of primary residence” (OER), which is how much homeowners would charge to rent their home unfurnished, without utilities. The BLS surveys homeowners in multiple urban areas every year to gather this information, replacing one-sixth of the data every year. The CPI could give a false low inflation reading due to low rents, even when home prices are high. Low rents can result from fewer renters and increased vacancies, as low interest rates spur more home purchases. At the same time, housing prices could rise due to increased market activity. This is why the CPI didn’t warn of asset inflation during the housing bubble of 2005. The CPI includes sales taxes. It excludes income taxes and the prices of investments, such as stocks and bonds. The CPI measures two commodities with wild price swings: food and energy commodities (oil and gasoline). These products are traded constantly on the commodities market. Traders can bid prices up or down based on news such as wars in oil-producing countries or droughts. The CPI often reflects these price swings as a result. The “core” CPI solves the problem of volatile food and energy prices by excluding them. The Fed has considered core CPI in the past when deciding whether to raise the fed funds rate (the interest rate for overnight loans between banks). The core CPI is useful because food, oil, and gas prices are volatile, and the Fed’s tools are slow-acting.
How CPI Affects the Fed
The Fed uses the CPI to determine whether economic policies need to be modified to prevent inflation. It uses contractionary monetary policy to slow economic growth when it recognizes that the rate of inflation is too high. It changes the fed funds rate to make loans more expensive, which tightens the money supply—the total amount of credit allowed into the market. Slowed growth and demand put downward pressure on prices. This returns the economy to a healthy growth rate of 2% to 3% a year.
How CPI Affects Other Government Agencies
The federal government uses the CPI to improve benefit levels for recipients of Social Security and other government programs that provide financial assistance.
How CPI Affects Housing and Investments
Landlords use the CPI forecasts to determine future rent increases in contracts. An increased CPI can depress bond prices, too. Fixed-income investments tend to lose value during inflation. Investors demand higher yields on these investments to make up for the loss in value as a result. These yield demands can increase interest rates, which then increases costs for businesses borrowing money to expand. The net effect is a decrease in earnings, which could depress the stock market.
Examples
The U.S. inflation rate by year shows that fluctuations in CPI used to be much worse. Inflation hit 14.4% year-on-year in 1946. The next time it came close to that was 1974, when it hit 11.1% year-on-year while the economy contracted 0.5%. The economic condition where the inflation rate is rising and the economy is contracting is called “stagflation.” Deflation occurred between 1930 and 1933. Prices fell by 10.7% in September 1932 compared to September 1931. Congress had imposed the Smoot-Hawley Tariff two years earlier, which created a trade war that lowered prices and worsened the Great Depression.
Benefits of the CPI
The CPI measures the rate of inflation, which is one of the greatest threats to a healthy economy. Inflation eats away at your standard of living if your income doesn’t keep pace with rising prices—your cost of living increases over time. A high inflation rate can hurt the economy. Everything costs more, so manufacturers produce less and may be forced to lay off workers. The CPI allows us to gauge these factors.
