Topic of the Week: Consumer Price Index

Consumer Price Index (CPI)

The Consumer Price Index, widely known as CPI, is an economic data point that gives key information on market movements specifically regarding inflation. CPI reports the average change monthly of consumer spending for a chosen group of goods and services. This chosen group is called the market basket, where there is a certain group of goods and services that the U.S. Bureau of Labor Statistics takes into account when measuring CPI. This basket of goods and services is evaluated every 2 years based on the most popular regions of spending for the average consumer. The basket is also weighed, with shelter/housing being the most important region for CPI because the average consumer spends a vast majority of their capital on housing. CPI is an important indicator of inflation because if general prices are high, that means inflation is taking a toll on the economy. The Federal Reserve uses the CPI as one of the factors that plays into their decision-making process when creating the levels for where they want inflation to be.

Why use CPI to measure inflation?

CPI is regarded as one of the most important economic indicators because it shows how the average consumer is being affected by inflation, which causes higher market prices. If Sally and many other American consumers have been increasingly spending more on housing across 3 months, this may indicate that inflation is getting worse, therefore motivating the Federal Reserve to reverse this momentum into inflation. CPI reports a heavy reflection of when inflation gains momentum on the market. When prices are getting high, average consumers may start asking their bosses for a raise at an increasing rate. Bosses may be more inclined to give raises during a period of inflation because while they give their employees a raise, they can also raise their prices, holding any losses back. The Consumer Price Index will give a good and obvious reflection on when these sequences of events start to occur, because the increased prices will fall upon the consumer’s spending of them. These sequences of events are a perfect representation of how inflation can maintain momentum into the market, which the Federal Reserve wants to completely avoid.

Change in Consumer Price Index vs Money Supply (inflation)

What are some problems with CPI?

- CPI only represents the average American consumer. Even though one might consider themselves to be an average consumer, they may follow less popular spending habits which may not be weighted very heavily in the market basket of CPI, therefore giving an inaccurate picture of inflation’s effect on them.

- The CPI market basket is only modified every two years. Even though that may seem sufficient, even the Federal Reserve uses other indexes that are modified more frequently to give a more accurate depiction of the market's movement. This point leads into other conflicts with CPI.

- CPI does not take into account product substitution. Because CPI is only modified every two years, if a certain trend dies off quickly because of an unfavorable increase in price, inflation may be overstated because consumers may start using other products in substitution of the overvalued one. This scenario is not reflected by the Consumer Price Index.

* Fun Fact- Starting January 2023, the U.S bureau of Labor Statistics started modifying the market basket annually instead of every two years.

Work Cited

Fernando, Jason. “Consumer Price Index (CPI) Explained: What It Is and How It's Used.” Investopedia, Investopedia, 26 Oct. 2022, https://www.investopedia.com/terms/c/consumerpriceindex.asp.