Consumer price index (CPI) is a summary report on the change in prices for a certain list of goods and services over a certain period of time. Basically, this list includes food, utilities, rent and other regular mandatory expenditures of the population. In other words, CPI indicates the real inflation rate for the people.
The Consumer Price Index is closely monitored, including participants in financial markets. For them, CPI as an indicator of inflation shows the state of the country’s economy, as well as potential changes in monetary and fiscal policy, which will affect the quotes in the future. However, apart from investors and traders, the Index is watched by consumers, politically active citizens, politicians, and other groups of the population.
It should be noted that the Consumer Price Index is calculated for each country separately. However, let’s take the US as an example. In America, the CPI is calculated by the US Bureau of Labour Statistics (BLS) every month. The monthly report can track the fluctuations in average prices month to month or year to year, which gives a broader picture.
To better understand how consumer prices have changed over time, let’s take a look at the historical trend of the U.S. Consumer Price Index:
A line chart displaying the historical trend of the U.S. Consumer Price Index (CPI) over the past decade, shows periods of inflation, deflation, and economic stability.
The calculation is based on more than 80,000 different goods and services, ranging from bread to a visit to the dentist. Thus, the U.S. Consumer Price Index reflects the needs of 93% of the U.S. population.
So, the next time you see CPI data, you’ll probably want to understand what’s behind those numbers, right? Well, let’s find out.
How is the CPI calculated?
The consumer price index (like any other economic indicator) is calculated using a special formula. In this case, it looks like this:
Annual CPI = (Cost of the consumer basket in the current year / Cost of the consumer basket in the previous year) × 100
Also, thanks to the Index, we can calculate the rate of inflation for the reporting period using the following formula:
Inflation rate = (New CPI – Previous CPI) / Previous CPI × 100
The cost of the consumer basket referred to in the formula above is literally collected from vendors and service providers in the field. The BLS takes data from 75 different neighborhoods and compiles it into one big table. To keep things fair, the price of each product or commodity is ‘weighted’ to reflect its relative importance to end consumers before being included in the index. Let’s return to our example. It’s unlikely that the average American goes to the dentist every week, but they almost certainly buy bread or a bottle of milk every day.
Interesting fact. The Consumer Price Index (we keep talking about the US) comes in several variations. For example, CPI-U, or CPI for all urban consumers, covers a basket of goods typical for more than 90% of American households. There is another variant, CPI-W, or the Consumer Price Index for Urban Workers and Clerks. CPI-W covers only 29% of the population and is used to calculate Social Security and benefit indexation. Of course, there are other options, which you can read about on the BLS website.
What is Included in the CPI Basket?
So, enough with the rhetorical examples. What exactly are the goods and services included in the CPI basket?
The BLS has its own categorization of goods and services. For example, housing, electricity, food, doctors, mechanics, and so on. By collecting data directly from service providers and retailers, the BLS is able to aggregate average prices for each item. The statistics are quite complex, but it is possible to understand them. For easier comprehension, we have prepared a summary table.
The relative importance of categories of goods and services in the CPI basket:
| Category | Relative Importance in CPI |
| Housing | 35.48% |
| Food | 13.69% |
| Medical Services | 6.75% |
| Transportation Services (insurance, airfare, etc.) | 6.31% |
| Energy (fuel, utilities) | 6.22% |
| New Vehicles | 4.39% |
It should be clarified that each category has dozens of subcategories, e.g. different types of food (dairy, meat, etc.).
Why is the CPI Important?
CPI is one of the most visible indicators of inflation in the country and, thus, the state of the economy as a whole. Let’s follow the chain of events.
The conventional wisdom is that a low (but not negative) and predictable inflation rate is good for the economy. Therefore, central banks around the world set a specific inflation rate that the government should aim for in order to maintain a stable economy. In the US, for example, the Federal Reserve is aiming for a 2% annual inflation rate. That’s not too much for money to simply depreciate. But it’s also not too low for people to be motivated to keep spending money, investing it in financial instruments, taking out loans to open a long-desired bakery, and so on.
Once again. If inflation (i.e. prices) is rising too fast, it means that there is a certain level of demand in the economy that producers cannot satisfy. If prices rise very slowly or fall at all, the situation is the opposite – there is little demand and a lot of supply. The reasons for such situations can be quite different, from global crises to unsuccessful budget policy. However, the conclusion is the same – something is wrong with the economy.
That is why everyone — businessmen, politicians, investors, and ordinary consumers — watches the Consumer Price Index. It allows them to see trends before the symptoms of problems appear in other areas.
How is the CPI used?
We have discussed the Consumer Price Index (CPI), its calculation, its importance, and so on. Now, we need to understand how to use the CPI data for our own purposes. We have tried to compile a list of all the main stakeholders who can use the CPI data in their daily work or lives.
- Central Bank (and financial market participants): A key function of the CPI is to show the trend in inflation, on the basis of which important financial and monetary decisions are made, such as increasing the central bank’s lending rate. Each of these decisions affects market sentiment and investor expectations. So if rumors of a bad inflation outcome are circulating, it may make sense to get out of your trades for a while.
- Entrepreneurs and business owners: The CPI can be used to make decisions about assigning or adjusting wages to employees. If the Consumer Price Index shows a large increase in inflation, a good employer will raise pay to cover the difference.
- Rental and Mortgage Rates: The rate of inflation directly affects landlords’ opinions on whether to raise rents.
- COLAs (Cost of Living Adjustments): Social security benefits, public subsidies, pension payments, and other forms of government assistance depend on CPI data. If inflation eats up some of the vulnerable’s income, then indexation should be carried out, and the costs of benefits and subsidies should be raised.
- Ordinary consumers: The CPI ultimately helps people understand how much their savings are now worth. You may be earning more, but has your purchasing power become greater?
As you can see, the Consumer Price Index is a really important tool for a wide range of people. Even those who are not directly involved in the financial markets can use it to improve their financial decision-making.
What Are the Limitations of the CPI?
Despite all the positives, the Consumer Price Index has a number of drawbacks that limit its use. Let us briefly go through them
- The CPI does not cover the entire population of a country: At best, the Index reflects the situation for just over 90% of the population. At the same time, the other 10% remain off the radar.
- There is a substitution error: Suppose you bought milk from one producer for a long time, but prices went up, and you switched to another cheaper alternative. Often, the BLS does not see this substitution in consumer preferences, and the named error appears.
- Emphasis on numbers: The price of a certain product may rise not because of inflation but because of improvements in product quality. Such changes are not often included in the CPI calculation.
- Exclusion of some costs: The CPI does not take into account income taxes, the price of investments (e.g., shares), or employer benefits.
Unfortunately, at this stage, we do not have a more comprehensive way to calculate consumer basket inflation, so the CPI remains a key tool. Or do we?
CPI vs. Other Inflation Measures (e.g., PCE)
In addition to the Consumer Price Index, there are several other indicators that deserve your attention.
CPI vs PPI
The Producer Price Index is another indicator from the BLS. However, it is used for other purposes.
The PPI focuses on how seller and producer prices have changed. It tracks inflation for manufacturing goods, services, construction, and so on.
CPI vs PCE
Personal Consumption Expenditures Index is a measure used by the US Federal Reserve when making monetary policy decisions. It is prepared by another agency called the Bureau of Economic Analysis.
The following chart compares CPI with PCE inflation indicator:
A comparative chart illustrating the differences between CPI and PCE inflation measures. The chart highlights how each index captures different aspects of price changes in the economy.
PCE looks a little deeper down the rabbit hole and estimates the inflation rate differently, taking into account an expanded list of categories of goods and services. Accordingly, CPI and PCE are used in different cases.
The best way to illustrate the differences is to look at medical costs. When calculating the Consumer Price Index, only the amount directly paid by a person for the service is taken into account. This seems fair. However, the Personal Consumption Expenditure Index adds other unnoticeable expenses in addition to the amount already mentioned. Such as, for example, insurance plans. These costs are paid by the government or employers, so they are not always obvious.
FAQ
How does the CPI affect the unemployment rate?
The Consumer Price Index and the unemployment rate have an inverse relationship. Tighter monetary policy often leads to fewer jobs, as was the case during the COVID-19 pandemic. Conversely, a softer attitude toward inflation allows for more job creation.
What are the criticisms of the CPI?
The consumer price index does not capture the entire population and all expenditures that the population may face. For example, the CPI does not take into account the rising cost of education for young people. Globally, the CPI covers 93% of the population. The remaining 7% are not included in the calculations.
How often are CPI reports published?
U.S. Consumer Price Index reports are released monthly on the tenth of the month. At the time of this writing, the next report will be released on March 12, 2025.
