One of Two

The common CPI, or CPI-U, measures the prices of goods and services typically purchased by all urban consumers. The less common CPI-W tracks the prices of goods typically purchased by urban wage earners and clerical workers. The CPI-W is an extension of the original CPI developed early in the 1900s that provided cost-of-living adjustment information to wage-earning workers (which is why the Bureau of LABOR Statistics oversees the CPI).

The CPI-U was developed in 1978 to provide a broader, more comprehensive measure of the economy's price level. Unless otherwise noted, the CPI reported by the popular press and used for economic analysis is invariably the broader CPI-U.

The Historical Trend

Consumer Price Index

• From 1974 to 1981, the CPI experienced a steep rise. This was a period of high inflation rates associated, at least in part, with tremendous increases in petroleum prices. While modest inflation tends to be a natural part of the U.S. economy, the high inflation experienced during the 1970s was most unusual.

Common Uses

• Price Level Indicator: The most common use of the CPI is as an indicator of the economy's price level, and perhaps even more importantly, as a means of estimating the rate of inflation. Together with the unemployment rate, the CPI-based inflation rate provides economists, business leaders, and government policy makers with two readily available (as in monthly), indicators of business cycle activity. Rising inflation rates and falling unemployment rates are the hallmark of business-cycle expansions. Falling inflation rates and rising unemployment rates are the signs of business-cycle contractions.


• Converting Nominal to Real: Economists, business leaders, and government policy makers often find it useful to convert current, or nominal economic indicators to real terms, that is to eliminate the inflationary increases in nominal values. The CPI is a handy way of accomplishing this. Suppose, for example, that Duncan Thurly is engaged in a heated discussion with his grandmother over the price of licorice when she was a child. Is licorice really more expensive now that it was then? A quick answer can be had by adjusting prices then and now with the CPI. This adjustment converts prices to real terms, effectively eliminating any role a rise in the overall price level has had on licorice. Any remaining price differences are then the result of different market conditions.


• Adjusting Payments: The CPI has become THE standard means of providing cost-of-living adjustments on a wide assortment of payments, especially those made by or to the Federal government. From the "payment by" side, The CPI is used to adjust Social Security benefits, Federal Civil Service pension payments, and food stamps. On the "payment to" side, the IRS uses the CPI to eliminate inflation-induced "bracket creep" from income taxes. Labor unions and employers also include CPI-based cost-of-living adjustments to union wages in most collective bargaining contracts. Adjusting such nominal payments with the CPI prevents an implicit or hidden decrease in the purchasing power of the payments resulting from a higher price level.

The How of Measurement

This means that the CPI requires two components, the quantities of goods and services used as weights (the market basket) and prices. The market basket used for the CPI is derived from the Consumer Expenditure Survey (CES) conducted for the BLS by the Bureau of the Census. For the CPI-U, the market basket is based on goods typically purchased by all urban consumers. For the CPI-W, the market basket is based on goods typically purchased only by urban wage earners and clerical workers.

Monthly prices are identified by systematically sampling retail outlets (that is, stores) frequented by consumers based on information obtained from what is called the Point-of-Purchase Survey (POPS). Identifying prices is a relatively elaborate process in which field representatives randomly sample product prices in a randomly selected group of stores in cities across the country. While the field representatives do not actually purchase any products, they scan the shelves for the prices of specific, pre-selected items used to compute the CPI. Each month, 25,000 retail outlets are visited by field representatives to collect 95,000 different prices.

Once price and quantity data are collected, it is a relatively straightforward process of calculating the CPI. Prices for the specific month are multiplied by market basket quantities to calculate total expenditures. These total expenditures for the month are then compared with total expenditures for the same market basket for the base period.

Crunching Numbers

The key questions are then: "How much are total expenditures for this fixed market basket using current prices? How do they compare to $22,678?" If expenditures are less than $22,678, say $18,392, then deflation has occurred. More realistically in the modern economy, if expenditures are more than $22,678, such as $27,052, then inflation has occurred. If expenditures are exactly $22,678, then prices are stable, neither inflation nor deflation.

Because the comparison of total expenditures can be somewhat cumbersome, the CPI is presented in a handy index form, with the base period equal to 100. The following formula helps illustrate this calculation:

CPI

=

total expenditures on market basket in current period total expenditures on market basket in base period

x 100

The CPI has a value of 100 in the base period because the "current period" and the "base period" are one and the same. As such, "total expenditures on market basket in current period" are exactly equal to "total expenditures on market basket in base period." That is, $22,678 divided by $22,678 times 100 is equal to 100.

For other periods, however, total expenditures on the market basket are not likely to be EXACTLY equal to $22,678, so the value of the index differs from 100. If, for example, total expenditures in the current period are $27,052, then the price index is 119.3. Alternatively, if total expenditures in the current period are only $18,392, then the price index works out to a value of 81.1.

A Family of Indexes

Data obtained for the CPI, however, provide sufficient detail to generate price indexes for specific major product categories, including: (1) food, (2) alcoholic beverages, (3) apparel, (4) housing, (5) transportation, (6) medical care, (7) personal care, (8) tobacco, (9) entertainment, and (10) education. Separate price indexes are also available for several major urban areas, including: New York, Los Angeles, Chicago, San Francisco, and Philadelphia, as well as four geographic regions of the country: northeast, midwest, south, and west.

Another handy index is generated for all products EXCEPT food and energy. This particular index, which is used to calculated what is frequently termed the core inflation rate, excludes food and energy products that are considered highly volatile and with markets that are subject to wide fluctuations independent of any overall price level changes.

Pros and Cons

• First, the CPI is computed each and every month, without fail. This is quite good. It is an extremely strong selling point for people needing current information about prices. The CPI provides an indicator of the price level and inflation for one month before the next is even half over. For household, business, and government decision makers in need of timely information, this is a very good thing.


• Second, the CPI measures prices of goods typically purchased by urban consumers. This is not necessarily a good thing for anyone interested in the economy's overall price level. The CPI excludes the prices of other production in the economy, most obviously, goods purchased by rural consumers. It also excludes capital goods purchased by the business sector and the whole myriad of purchases made only by the government and foreign sectors. In that urban consumption purchases constitute about 60 percent of the economy's aggregate production, it obviously misses some prices. This is not good.


• Third, the CPI measures the prices of a fixed market basket of goods. This is not necessarily a good thing for anyone interested in the price level of the economy's current production. While the folks at the BLS try to periodically adjust this market basket for changing consumer tastes, technology, and relative prices, the CPI for any given month is NOT based on goods purchased during THAT month. The CPI is based on the prices of goods purchased by consumers during some OTHER period. This is not good.