The Consumer Price Index (CPI) is a monthly measure of how the aggregate costs of consumer goods and services in the United States are changing. Economists use CPI to help them understand whether the economy is in a period of inflation or deflation, and individuals can use it to get a sense of where prices might be headed.
How Does the CPI Work?
The CPI measures the change of the weighted-average prices paid by urban consumers for select goods and services, according to the Bureau of Labor Statistics (BLS) . In other words, the metric tracks the rise and fall of prices over a given period of time.
The BLS produces indexes that cover two populations: CPI-U covers all urban consumers, representing 93% of the population. And CPI-W represents urban wage earners and clerical workers, representing 29% of the population. The CPI excludes people who live in rural areas, the military, and imprisoned people.
What Goods and Services Does the CPI Cover?
The CPI tracks prices for a basket of goods and services people commonly buy in eight major categories, including:
• Food and beverage
• Recreation
• Apparel
• Transportation
• Housing
• Medical care
• Education and communication
• Various services
The CPI tracks more than 200 categories of items, and within each category it samples hundreds of specific items at various businesses which serve to represent the thousands of items available to consumers. In addition to these categories, CPI includes government-charged user fees like water, sewages, tolls, and auto registration fees. It also factors in taxes associated with the price of goods such as sales tax and excise tax. However, it does not include Social Security taxes or income taxes that aren’t directly related to the purchasing of goods and services.
The CPI also does not include the purchase of investments, like stocks and bonds.
CPI Formula
Each month, the BLS contacts retailers, service providers, and rental spaces across the country gathering prices for about 80,000 items. It uses this data to calculate CPI using the following formula:
CPI = Cost of the Market Basket in a Given Year/Cost of the Market Basket in the Base Year.
The result is multiplied by 100 to express CPI as a percentage.
The BLS uses the years 1982-1984 as its base year. It set the index level during this period at 100.
How to Calculate the CPI
To understand how to calculate CPI, let’s take a look at a simplified example.
CPI Example
Imagine the cost of a basket of goods in 1984.
| Sweatshirt | 1 dozen eggs | Movie ticket | |
|---|---|---|---|
| Price in 1984 | $10 | $1.50 | $5 |
| Quantity | 2 | 6 | 10 |
| Total Cost | $20 | $9 | $50 |
When you total the price of these goods you get $79. Using the CPI formula above you take $79/$79 x 100 = 100%. This is where the 1984 base rate of 100 comes from.
Now let’s consider the same basket of goods in 2021.
| Sweatshirt | 1 dozen eggs | Movie ticket | |
|---|---|---|---|
| Price in 2021 | $24 | $3 | $15 |
| Quantity | 2 | 6 | 10 |
| Total Cost | $48 | $18 | $150 |
When you total the prices of these goods you get $216. Now, when you plug this into the CPI formula you get $216/$79 x 100 = 273%. You can now tell that from 1984 to 2021 prices for this particular basket of goods have risen by 173%.
Is It Good if the CPI Goes Up?
Some inflation can be a good thing, the economy is continuing to grow. The Federal Reserve currently targets an inflation rate of 2% because it believes that creates the ideal environment for price stability and maximum employment. However, high inflation can make it difficult for consumers to afford basic necessities, like food and transportation, signalling trouble in the economy and the potential for a recession.
In October 2021, the inflation rate was 6.2% , the highest rate since 1990, year-over-year, due in part to continued supply chain issues, rebounding prices, and labor issues.
Recommended: Is Inflation Good or Bad?
How Is CPI Used?
The CPI has a number of uses. Here’s a look at a few:
A Measure of Inflation and Deflation
The CPI is the most common way to measure inflation, the economic trend of rising prices over time, or deflation, the trend of falling prices. The federal government sets a target inflation rate of 2% annually, and the CPI can help the government understand whether or not its monetary policy is effective in meeting this target.
Recommended: What Is Deflation and Why Does It Matter?
A Measure of Cost-of-Living
Economists also use CPI as a measure of cost of living, the amount of money you need to cover basic expenses, such as housing, food, and health care. This is important because the government may make cost-of-living adjustments to programs such as Social Security benefits. As the cost of living rises, benefit amounts may be adjusted higher to keep up with the rising costs of goods.
Employers may also look at the cost of living to help them set competitive salaries and determine when to raise wages for employees.
As a Deflator of Economic Series
Economists also use CPI to adjust other series of economic values to take price changes into account or translate them into inflation-free dollars. For example, they can use CPI to determine the purchasing power of a consumer’s dollar. Purchasing power is essentially the amount of goods and services a dollar can buy over various time periods, and it decreases as prices increase.
What Are the Limitations of Using the CPI?
The CPI is a useful measure in many ways, but it does have some limitations. First, it doesn’t apply to all populations in the United States. CPI considers urban populations alone, so it is not necessarily representative of the costs for those who live outside of those areas.
Also, the CPI calculation does not take into account all of the goods and services available to consumers or new technologies not yet considered consumer staples. What’s more, the metric does not provide any contact into what’s causing prices to move up and down, such as social or environmental trends.
The Takeaway
Rising inflation decreases the value of individuals’ cash savings over time. Investing in stocks, bonds and other investments that offer inflation-beating returns may help consumers protect the value of their savings. Understanding CPI, and how it’s moving, can help you devise a strategy for your investment portfolio.
An easy way to get started building the portfolio is by opening an online brokerage account with SoFi Invest®. Using SoFi, you purchase stocks, exchange-traded funds, and fractional shares through the Active Investing service, or have a personalized portfolio built for you through the Automated Investing service.
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