Consumer Price Index

The Consumer Price Index (CPI) is a statistical measure of the average prices paid by consumers for a typical “market basket” of goods and SERVICES. Measuring the rate of change in prices is important to policy makers. Price changes are a critical concern in MONETARY POLICY, essential in evaluating ECONOMIC CONDITIONS, and a major factor when indexing spending and taxes. The CPI is an important and controversial measure of price changes. The controversy centers on how the CPI is calculated and, thus, whether it is representative of INFLATION as experienced by American consumers. Most U.S. economists agree the CPI overstates the rate of inflation experienced by American consumers. Calculated by the BUREAU OF LABOR STATISTICS (BLS) since 1917, the CPI is measured monthly by sampling prices around the country for a “typical market basket” of goods and services purchased. An average price for each good and service is derived from the sampling procedure, which is then multiplied by the assumed amount typical households purchase. This process “weights” the goods and services by the relative importance in consumers’ budgets. The sum of the prices times quantities are then divided by the cost of the same goods and services in a base year to create a price index. Price index = cost of market basket today x 100 cost of market basket in base year One of the problems with the CPI is what is “typical.” Especially in the 1990s and early 21st century, rapid changes in technology have made many new products available to consumers. For example, cellular telephones, which have been available since the early 1990s, were not included in the CPI until 1998. Similarly, the CPI used the price of coal as a measure of the cost of heating long after it was replaced by heating oil and natural gas in most American homes. Related to the problem of what constitutes typical purchases by consumers is the issue of quality changes. American consumers are paying more for health care but also have significantly improved products and services available to them. The CPI does not accurately distinguish between increased prices and higher prices for improvements in quality. The U.S. Congress created commissions to investigate the country’s Consumer Price Index in 1961 (Stigler Commission) and again in 1997 (CPI Commission). The CPI Commission estimated changes in quality and introduction of new PRODUCTs resulted in approximately a half percentage point upward bias in the index. Another problem is that the CPI does not always capture changes in CONSUMER BEHAVIOR. Because the amount of each product is fixed in the index, the CPI does reflect consumer substitution. For example, if citrus fruit prices rise rapidly due to a freeze in the southern part of the country, consumers will likely substitute other fruit products in their purchases, but the CPI reflects the amount of citrus fruits typically purchased. Consumers’ cost of fruit will therefore be lower than the amount estimated in the index. In 1997 the CPI Commission estimated this substitution bias overestimated inflation by 0.4 percentage points. The CPI Commission also reported two other smaller sources of bias measuring the index. Most sampling takes place during the week, but retailers often reduce prices on weekends, and thus the index does not accurately reflect the prices paid by consumers. Similarly, the Bureau of Labor Statistics rotates the retail stores included in the sampling procedure each year, but the Commission found that the process does not fully reflect consumers’ substitution of discount and superstore outlets for traditional retailers. As stated earlier, the CPI is used to measure the change in prices paid, reflecting the cost of living. The CPI is used to address the question: “How much more INCOME will consumers need to be just as well off at the current price level as compared to old prices?” Private contracts for products, borrowing, and approximately one-third of the FEDERAL BUDGET are automatically escalated each year by the change in the CPI. Many union wage agreements (COST OF LIVING ADJUSTMENTS) and SOCIAL SECURITY payments are examples of contracts tied to changes in inflation as measured by the CPI. Even small changes in the CPI, when compounded over time, result in large changes in wages and payments. The Bureau of Labor Statistics produces two other inflation indices, the PRODUCER PRICE INDEX (PPI) and the GDP deflator.