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business newsReal or Ridiculous? The Consumer Price Index
How what we spend for milk and eggs tells us where the economy is going.
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The CPI is the most widely used measure of prices in the United States, and by extension, inflation. It's designed to show how the cost of all purchases by a typical urban family has changed over time. The information on these price changes inform economic decisions in government, business, and labor, and play an important role in fiscal and monetary policies of the President, Congress, and the Federal Reserve.
In 2009, there was a 2.7 percent rise in the CPI, which followed a 0.1 percent increase in 2008, which had been the smallest gain in more than a half century.
So how does the CPI work? The Bureau of Labor Statistics (BLS) surveys market prices for a market basket that's constructed to represent the consumption of a typical family of four living in a typical American city. Since this is an urban group, it represents about 87 percent of the total US population; not included are spending habits of people in rural non-metropolitan areas, farm families, people in the military, and those in institutions like prisons, according to the BLS. The base period of the index is currently 1982-1984.
Designing that market basket is incredibly complex. The BLS sends its employees out to survey supermarkets, gas stations, hardware stores, and so on -- some 23,000 retail outlets in 87 cities, according to Macroeconomics (2005), the textbook written by Paul Krugman and Robin Wells. Their employees are like detectives scouring the Safeways (SWY), Walmarts (WMT), and Home Depots (HD) of this country.
The BLS has classified the expenditures that go into this basket into more than 200 categories, arranged into eight major groups: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. Some categories, such as gasoline, are weighted greater than others, depending on the overall spending habits of consumers. Housing expenditures, for instance, consume about 40 percent of the BLS’s basket.
The CPI is one of the most important economic measurements because it has a direct impact on things like welfare payments and wage adjustments for millions of workers. With government assistance, for example, over 50 million people receiving Social Security, and military and Federal Civil Service retirees, have cost-of-living adjustments tied to the CPI. Same goes for food-stamp recipients. Even within the proposed health-insurance legislation, one major point of contention has been where to set an excise tax on high-cost insurance policies; indexing it just above the CPI would generate considerable cost-savings for the government.
The CPI has been calculated since 1913. Since 1940, the CPI has risen steadily, although less so recently than in the inflation-prone 1970s and early 1980s, when inflation reached 15 percent. The CPI is usually considered in a danger zone when it's either negative or rises only slightly -- signaling deflation -- or, obviously, when prices go up dramatically, say by double-digit percentages, meaning inflation.
The CPI remains the consensus estimate of inflation. However, although the government takes great care in measuring prices, many economists believe that the CPI somewhat overstates the actual rate of inflation. The reasons, according to Krugman and Wells, are attributable to the changing mix of consumption over time, and innovation, particularly since 1985 (the base period for the current measurement) in areas like information technology. Innovation basically makes a given amount of money worth more.
Lastly, in recent years the CPI has been volatile because of large swings in food and energy prices. For this reason, the Federal Reserve and many economists watch “core inflation” instead, which excludes those categories. Which would mean that core inflation rose 1.8 percent in 2009, slightly less than the overall 2.7 percent increase.
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