United States Consumer Price Index

CPI-U 1913–2006; Source: U.S. Department Of Labor

The U.S. Consumer Price Index is a time series measure of the price level of consumer goods and services. The Bureau of Labor Statistics, which started the statistic in 1919, publishes the CPI on a monthly basis. The CPI is calculated by observing price changes among a wide array of products in urban areas and weighing these price changes by the share of income consumers spend purchasing them. The resulting statistic, measured as of the end of the month for which it is published, serves as one of the most popular measures of United States inflation; however, the CPI focuses on approximating a cost-of-living index not a general price index.

The CPI can be used to track changes in prices of all goods and services purchased for consumption by urban households, i.e., of the consumer basket. User fees (such as water and sewer service) and sales and excise taxes paid by the consumer are also included. Income taxes and investment items (like stocks, bonds, life insurance, and homes) are not included. The index measures inflation faced by consumers who live in urban areas designated by the U.S. Bureau of the Census.

Scope of the CPI

BLS calculates the CPI for two population groups, one consisting only of wage earners and clerical workers and the other consisting of all urban consumers. In addition, a Core CPI, which excludes volatile food and energy prices and a Chained CPI are also widely used measures of consumer inflation.

CPI for Urban Wage Earners and Clerical Workers (CPI-W)

The urban wage earner and clerical worker population consists of consumer units with clerical workers, sales workers, craft workers, operative, service workers, or laborers. (Excluded from this population are professional, managerial, and technical workers; the self-employed; short-term workers; the unemployed; and retirees and others not in the labor force.) More than one half of the consumer unit's income has to be earned from the above occupations, and at least one of the members must be employed for 37 weeks or more in an eligible occupation.The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) is a continuation of the historical index that was introduced after World War I for use in wage negotiation. As new uses were developed for the CPI, the need for a broader and more representative index became apparent.

CPI for All Urban Consumers (CPI-U)

The all-urban consumer population consists of all urban households in Metropolitan Statistical Areas (MSA's) and in urban places of 2,500 inhabitants or more. Non-farm consumers living in rural areas within MSA's are included, but the index excludes rural consumers and the military and institutional population. The Consumer Price Index for All Urban Consumers (CPI-U) introduced in 1978 is representative of the buying habits of approximately 80 percent of the non-institutional population of the United States, compared with 32 percent represented in the CPI-W. The methodology for producing the index is the same for both populations.

Core CPI

The core CPI index excludes goods with high price volatility, such as food and energy. This measure of core inflation systematically excludes food and energy prices because, historically, they have been highly volatile and non-systemic. More specifically, food and energy prices are widely thought to be subject to large changes that often fail to persist and do not represent relative price changes. In many instances, large movements in food and energy prices arise because of supply disruptions such as drought or OPEC-led cutbacks in production.

Chained CPI for All Urban Consumers (C-CPI-U)

This index applies to the same target population as the CPI-U. The same raw data are used, but a different formula is employed to calculate average prices. The chained CPI was developed to overcome a shortcoming of the CPI-U series, which does not account for the changes that people make in the composition of goods that they purchase over time, often in response to price changes. The alternative method of the C-CPI-U is intended to capture consumers' behavior as they respond to relative price changes.

History of the CPI

The Consumer Price Index was initiated during World War I, when rapid increases in prices, particularly in shipbuilding centers, made an index essential for calculating cost-of-living adjustments in wages. To provide appropriate weighting patterns for the index, so that it would reflect the relative importance of goods and services purchased in 92 industrial centers in 1917-1919. Periodic collection of prices was started, and, in 1919, the Bureau of Labor Statistics began publication of separate indexes for 32 cities. Regular publication of a national index, the U.S. city average began in 1921, and indexes were estimated back to 1913 using records of food prices.

Because people's buying habits had changed substantially, a new study was made covering expenditures in the years 1934-1936, which provided the basis for a comprehensively revised index introduced in 1940. During World War II, when many commodities were scarce and goods were rationed, the index weights were adjusted temporarily to reflect these shortages. In 1951, the BLS again made interim adjustments, based on surveys of consumer expenditures in seven cities between 1947 and 1949, to reflect the most important effects of immediate postwar changes in buying patterns. The index was again revised in 1953 and 1964.

In 1978, the index was revised to reflect the spending patterns based upon the surveys of consumer expenditures conducted in 1972-1974. A new and expanded 85-area sample was selected based on the 1970 Census of Population. The Point-of-Purchase Survey (POPS) was also introduced. POPS eliminated reliance on outdated secondary sources for screening samples of establishments or outlets where prices are collected. A second, more broadly based CPI for All Urban Consumers, the CPI-U was also introduced. The CPI-U took into account the buying patterns of professional and salaried workers, part-time workers, the self-employed, the unemployed, and retired people, in addition to wage earners and clerical workers.).

Perceived overestimation of inflation

Main article: Boskin Commission

In 1995, the Senate Finance Committee, appointed a commission to study CPI's ability to estimate inflation. The CPI commission found in their study that the index overestimated the cost of living by a value between 0.8 to 1.6 percentage points. Because the CPI is so widely used as an inflation adjustment, if it is overestimated, even by such a small percentage, has several consequences.

If CPI overestimates inflation, then claims that real wages have fallen over time could be unfounded. Additionally, real GDP growth, which is calculated using the CPI, would be severely underestimated. An overestimation of only a few tenths of a percentage point per annum compounds dramatically over time. In the 1970s and 80s the Federal Government began indexing several transfers and taxes including social security (see above Uses of the CPI). The overestimation of CPI would imply that the increases in these taxes and transfers have been greater than necessary, meaning the government and taxpayers have overpaid for them.

The Commission concluded that more than half of the overestimation was due to slow adjustments in the index to new products or changes in product quality. Because the index weights are only adjusted once every ten years, the CPI does not account for new technologies that are adapted by consumers quickly. For example, by 1996 there were over 47 million cellular phone users in the United States, but the weights for the CPI did not account for this new product until 1998. This new product lowered costs of communication when away from the home. The commission recommended that the BLS update weights more frequently than ten years to prevent new products from causing upward bias in the index.

Additional upward biases were said to come from several sources. Fixed weights to do not accommodate consumer substitutions among commodities, such as buying more chicken when the price of beef increases. Because the CPI assumes that people continue to buy beef, it would increase even if people are buying chicken instead. The Commission also found that 99% of all data were collected during the week, although an increasing amount of purchases happen during the weekend. Additional bias was said to stem from changes in retailing that were unaccounted in the CPI.

Perceived underestimation of inflation

Some critics believe however, that because of changes to the way that the CPI is calculated, and because energy and food price changes are currently excluded from the Federal Reserve's calculation of "core inflation", that inflation is being dramatically underestimated. The second argument is unrelated to the CPI.

The Federal Reserve's policy of ignoring food and energy prices when making interest rate decisions is often confused with the Bureau of Labor Statistics' measurement of the CPI. The CPI does count food and energy prices. In fact, the Federal Reserve no longer even uses the CPI to calculate inflation, preferring to use core PCE instead.

Changes in CPI calculation due to the Boskin Commission have led to dramatic cuts in inflation estimates. Using pre-Boskin methods—the methods still in use by most other countries—the current U.S. inflation is estimated to be around 7% per year.

Calculating the CPI

The calculation of the CPI involves a hybrid methodology consisting of two stages:

In the first stage, elementary indices are created to show the price levels of very similar goods in the same area. For instance, there is an elementary index for "sports equipment in Seattle". As of June 2007, there are 8,018 of these elementary indices. (8,018 = 211 * 38, where 211 is the number of categories ("item strata") and 38 is the number of geographical areas considered.) All but a few of the elementary indices are based on geometric means formulas.

In the second stage, the elementary indices are combined to create a number of aggregate indices, including the CPI. (The CPI is an aggregate of all 8,018 basic indices. BLS also computes other aggregates computed uses smaller subsets of the basic indices. For instance, there is an all-items index for Boston, and an all-areas index for electricity.)

These aggregate indices (including the CPI) are calculated using a Laspeyres index computed as:

$\Delta P_{L}={\frac {\sum _{i}p_{i_{1}}\,q_{i_{0}}}{\sum _{i}p_{i_{0}}\,q_{i_{0}}}}$

where:

$\,\Delta P_{L}$ is the change in price level,

$\,p_{i_{0}}$ is the price of each good $\,i$ in the first period,

$\,q_{i_{0}}$ is the quantity of each good $\,i$ in the first period,

$\,p_{i_{1}}$ is the price of each good $\,i$ in the second period.

Weights of the CPI

The weight (or quantities, to use the above terminology) of an item in the CPI is derived from the expenditure on that item as estimated by the Consumer Expenditure Survey. This survey provides data on the average expenditure on selected items, such as white bread, gasoline and so on, that were purchased by the index population during the survey period. In a fixed-weight index such as the CPI, the implicit quantity of any item used in calculating the index remains the same from month to month.

A related concept is the relative importance of an item. The relative importance shows the share of total expenditure that would occur if quantities consumed were unaffected by changes in relative prices and actually remained constant. Although the implicit quantity weights remain fixed, the relative importance changes over time, reflecting average price changes. Items registering a greater than average price increase (or smaller decrease) become relatively more important.

Method evaluation

This two-stage method is relatively new. Before 1999, CPI used only Laspeyres indices, measures of the price changes in a fixed market basket of consumption goods and services of constant quantity and quality bought on average by urban consumers, either for all urban consumers (CPI-U) or for urban wage earners and clerical workers (CPI-W). The Laspeyres index, however, systematically overstates inflation because it does not take into account changes in the quantities consumed that may occur as a response to price changes. The Laspeyres formula works under the assumption that consumers always buy the same amount of each good in the market basket, no matter what the price. The geometric mean price index formula used to calculate many of the elementary indices, in contrast, assumes that consumers will always spend the same amount of money on a good and shift the quantity they buy of that good based on the price.

Uses of the CPI

• As an economic indicator. As the most widely used measure of inflation, the CPI is an indicator of the effectiveness of government fiscal and monetary policy. Especially for inflation targeting monetary policy by the Federal Reserve; however, the Federal Reserve System has recently begun favoring the Personal consumption expenditures price index (PCE) over the CPI as a measure of inflation. Business executives, labor leaders, and other private citizens also use the CPI as a guide in making economic decisions.
• As a deflator of other economic series. The CPI and its components are used to adjust other economic series for price change and to translate these series into inflation-free dollars.
• As a means for indexation (i.e. adjusting income payments). Over 2 million workers are covered by collective bargaining agreements which tie wages to the CPI. In the United States, the index affects the income of almost 80 million people as a result of statutory action: 47.8 million Social Security beneficiaries, about 4.1 million military and Federal Civil Service retirees and survivors, and about 22.4 million food stamp recipients. Changes in the CPI also affect the cost of lunches for the 26.7 million children who eat lunch at school. Some private firms and individuals use the CPI to keep rents, royalties, alimony payments and child support payments in line with changing prices. Since 1985, the CPI has been used to adjust the Federal income tax structure to prevent inflation-induced increases in taxes.

See also

• Consumer Price Index
• Cost of Living
• Boskin Commission
• Stigler Commission
• Inflation
• Core inflation
• Bureau of Labor Statistics
• Producer Price Index
• GDP deflator
• Monetary Policy
• Hedonic regression
• Implicit price deflator (IPD)
• List of economics topics

External links

• U.S. Department of Labor, Bureau of Labor Statistics, CPI Home Page
• US Inflation Calculator & CPI US Inflation Calculator based on CPI data (1913-current).
• Note on a New, Supplemental Index of Consumer Price Change (Introduction to C-CPI-U)