How is Inflation Measured? Understanding the Consumer Price Index

You'll hear analysts talking about inflation when prices rise in different sectors. Inflation occurs when currency values devalue over time. As goods and services get more expensive, your money's purchasing power decreases.

The first time people notice inflation is when they realize that a product or service they purchase regularly has become more expensive. Perhaps your receipt at the grocery store or petrol station is higher than you expected. Not all prices increase at the same pace, and some consumers might find that they're not spending more than they did a year earlier.

How is inflation measured, then? Calculating inflation can be complicated, even though it may seem like an easy question. The economy is large and complex. Not everyone is interested the same products and services.

Understanding the Consumer Price Index is essential to understanding how inflation is calculated.

Takeaways

The PCE and core price indexes can help to address some of the shortcomings of solely relying on the CPI.

What is inflation?

Inflation is the result of the general change in the prices across the entire economy. Inflation is an increase in prices, while deflation means a decrease.

Do not confuse these terms with stagflation. This is a scenario where both unemployment and inflation are high. The Fed is in a difficult position when it comes to stagflation, as raising interest rates may result in further unemployment.

Analysts measure inflation by looking at the changes in prices of a basket. This basket contains many items that Americans purchase every day, like groceries, gas and medical supplies. Every month, data collectors track the prices of all these items to see if they are rising or falling.

Inflation reports are usually released every month. The inflation rate can fluctuate from month to month, especially if you focus on a specific good or service. These reports also show changes over the past 12 months to provide a better picture of overall price trends.

Measures of inflation

While the U.S. Consumer Price Index is widely known as the best measure of inflation, there are other measures that attempt to capture changes in prices. These measures are useful to different types of consumers and businesses.

Consumer Price Index

CPI is calculated by the Bureau of Labor Statistics. The CPI measures the change in prices consumers pay over time for goods and services.

The CPI number that consumers are most familiar with is a total of all goods and services. There are indices available for geographical areas and specific verticals.

The CPI weights each item according to the amount that an average American spends. CPI is less affected by goods and services which make up a smaller percentage of Americans' expenditures. The BLS uses its Consumer Expenditure Surveys program (CE) to evaluate the importance of each item within a basket of goods and/or services.

The CPI sample is created through a procedure called initiation. The CPI data collector visits a store to select an item. They may, for example, choose a cereal box that comes in two sizes. To determine the probability of a purchase, data must be collected about how many people are buying each size. The data collector will then randomly select one of the sizes to track and record its price each month.

Every four years, items are naturally rotated out of the CPI basket. The BLS records prices for approximately 80,000 items per month, which are divided into eight categories, including:

Other goods and Services

Price Index for Personal Consumption

The Personal Consumption Expenditures Price Index (PCE) is another popular measure of inflation. The core PCE price index (which excludes food and fuel) is not as well-known as the CPI but it's important, because it's used by the Federal Reserve to set monetary policy. This measure is developed by the Bureau of Economic Analysis.

The PCE price index is a basket of goods, like the CPI. However, in some cases, the relative weights are different. Here are a few of the key differences.

CPI reports for 2022 attributed shelter an 'importance relative' (the percentage that consumers spent on this category) of approximately 34%. Comparatively, the PCE placed shelter at 16% during the same time period. In 2015, BEA reported that medical costs were ranked at 22% importance, while CPI rated it as 8.4% relative importance.

According to the Brookings Institute one of the reasons for the different weights in medical costs is because the PCE includes all consumption items. The PCE includes costs such as premiums, deductibles, and expenses covered by Medicare and employer-sponsored insurance. CPI only measures direct consumer costs.

These different weights have a different impact on their respective indices. Changes in healthcare costs, for example, will have a significant impact on the PCE while changes in housing will have a greater effect on the CPI.

Many articles debate whether CPI is better than PCE. PCE is known to be less volatile than CPI. Others prefer the CPI because they believe it represents better inflation's effect on consumer spending.

Core Inflation

As a base, core inflation can be calculated using any index, including the CPI and PCE. The monthly omission of certain items, like gasoline and food costs can make the overall price trend less accurate.

It is expected that removing the volatile items from inflation measures will give a more consistent view of inflation. Core inflation can be distorted in certain cases.

We can compare the core CPI with the trimmed-mean CPI of Cleveland Fed to better understand why. The core CPI measures the same goods and services every month, but the trimmed-mean CPI only includes the volatile items.

It is easy to see why the CPI trimmed-mean approach would produce more predictable results. One-off events, such as natural catastrophes, could cause an unexpected and sudden rise in the prices of items that are normally stable. By adjusting for these events each month, the CPI trimmed-mean will better reflect the overall trends in prices.

Why do we have so many ways to measure inflation?

CPI data is usually used by the BLS when we hear about inflation. As you should now know, the CPI does not measure inflation perfectly. No measure of inflation can be considered accurate. The CPI alone cannot tell us everything.

Likewise, people care about different price changes depending on the sector of the economy. Railroad companies, for example, will be more concerned with the price of diesel fuel than the price of milk.

In the same way, Chicago consumers will be more concerned with inflation rates in their city rather than Los Angeles. Multiple indices will be needed to get a full picture of inflation.

CPI Limitations

Consumer Price Index has limitations in terms of what it can say and its accuracy. Remember that the CPI does not reflect the true prices of products across the nation. The report will not tell you whether eggs are cheaper or more expensive in Montana, Oklahoma or anywhere else. It only shows where prices increased the fastest.

Similarly, the CPI does not apply to all populations. CPI-U records, for instance, prices of items sold to urban populations. A rising inflation rate does not necessarily reflect an increase in the price of items that you buy.

CPI shouldn't be used to calculate living costs across the country. The BLS refers to the CPI as a "conditional cost of living measure" because it doesn't reflect expenses incurred through social and environmental factors, including taxes.

Data collection will always have sampling and non-sampling mistakes. Look at more than one index in order to get a better idea of the general trends in U.S. prices.

Final Words

Inflation is a general rise in the prices of goods and services throughout an economy. Analysts measure the inflation rate by examining price changes within an index. The BLS publishes the CPI as a report every month. Other measures of inflation include the PCE Price Index and core inflation. These measures can help to address problems with the CPI. They may, for example, remove items that are highly volatile or weight items with a tendency to swing differently.

It is difficult to measure inflation, so a single measurement can be inaccurate or not represent certain industries or regions. Multiple measures of inflation help paint a full picture of the economy and address its nuances.