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Understanding the Consumer Price Index

The highs and lows of the economy affect people and markets in a variety of ways. While some sectors may be thriving, others may be sluggish. One economic indicator used to gauge the state of the American economy is the Consumer Price Index (CPI), which measures the rate of inflation in the United States.

Inflation, which is defined as a rise in the average price level of all goods and services, can have a significant impact on the American economy and your financial affairs. Understanding the CPI, and the ways it measures inflation, can provide a strong foundation for understanding not only market and economic swings, but also the ways in which fiscal and monetary policies affect America's finances, and your own.

Determining the Market Basket

Each month, the U.S. Bureau of Labor Statistics (BLS) surveys prices for a "market basket" of goods and services in order to create an economic "snapshot" of the average consumer's spending, which is quantified as the CPI. Actual expenditures are classified into more than 200 categories and eight major groups. These include the following:
  • Food and Beverages: common groceries, wine, and full-service meals

  • Housing: rent, furniture, and fuel oil

  • Apparel: clothing, shoes, and jewelry

  • Transportation: vehicle lease and purchase costs, gasoline, auto insurance, and airfare costs

  • Medical Care: doctor's visits, hospital care, and prescription drugs

  • Recreation: television, pets, admission to events, and sporting equipment

  • Education and Communication: college tuition, postage, telephone service, and computer equipment

  • Other Goods and Services: tobacco, haircuts, personal services, and funeral expenses.

Because the CPI assesses expenditures in these fixed categories, the CPI is a valuable tool for comparing the current prices of goods and services to prices last month or last year.

Interpreting and Using the CPI

As a measure of inflation, the CPI has three main functions. First, it serves as an indication of economic health and the effectiveness of government policy. To a certain extent, some inflation indicates a healthy economy; however, too much inflation, or no inflation at all, can indicate economic trouble. In fact, the Federal Reserve Board (the Fed) aims for a yearly inflation rate of 2%.

If the CPI constantly fluctuates, Congress and the Fed may take measures to control the amount of inflation and stimulate economic growth. As a result, business executives, labor leaders, and individual consumers may change their spending and saving patterns. For example, the Fed may attempt to curb rising inflation by raising short-term interest rates. This increase in the cost of borrowing money is likely to slow personal and business spending. Conversely, if the economy is not growing, the Fed may attempt to stimulate growth by lowering short-term interest rates. Lowering the cost of borrowing is likely to trigger increased spending among businesses and consumers.

As a second function, the CPI helps determine the "real" value of a dollar over time by removing the effects of inflation. As prices increase, the purchasing power of a dollar decreases. Therefor, more dollars are needed to purchase the same amount of goods and services. Comparing inflation-free wages and prices allows economists to determine the actual earning and spending patterns of the American consumer, including what percentages of money are being saved or spent in certain areas.

Lastly, the CPI is used as a means of adjusting salaries and government benefits to account for price changes. For example, as a result of collective bargaining agreements, the wages of millions of American workers increase according to the amount of change in the CPI. The CPI is also used to determine the benefits of almost 50 million people covered under government programs, including Social Security beneficiaries and military and Federal Civil Service retirees. In addition, changes in CPI can be seen in the eligibility requirements for SNAP (food stamp) benefits and school lunch programs, as well as in rents, royalties, alimony payments, and child support payments determined by private firms and individuals. Finally, the CPI has been used to adjust the Federal income tax structure to prevent increases in tax rates caused solely by inflation (source: Bureau of Labor Statistics, “Addendum to Frequently Asked Questions,” http://www.bls.gov/cpi/cpiadd.htm#2_3).

For More Information

Inflation can have a serious impact on the American economy as it affects both government policy and the spending and saving patterns of businesses and consumers. Understanding and following changes in the CPI can help you identify how the value of the dollar changes and estimate how inflation may affect your future plans. The U.S. Department of Labor (DOL) publishes current BLS information on the CPI each month. For more information, visit their website at www.bls.gov/cpi.

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