What Is the Consumer Price Index and How Is It Used?

Infpgraphic that explains what the consumer price index is

The Bureau of Labor Statistics (BLS) regularly checks the average price of over 80,000 consumer goods and services. These goods are primarily bought by urban households and represent about 87% of the country’s population. The average price of this collection of consumer goods is measured every month. This monthly measurement is the Consumer Price Index or CPI. Comparing the Consumer Price Index from month to month is one of the best ways to calculate how much prices have changed over time and a good indication of where inflation is heading.

“Food and energy account for a significant portion of household budgets, so the Federal Reserve’s inflation objective is defined in terms of the overall change in consumer prices.”

Janet Yellen

Who Uses the Consumer Price Index and How?

As a measure of inflation

The CPI is the most common measure of inflation. Unfortunately, one of the biggest threats to an economy’s health is inflation. Luckily, the CPI helps us monitor and combat inflation that is out of control and hurts the economy. In the short term, inflation will cause prices to go up. As a result, if your income stays the same, you start to pay more for goods and services. In the long term, it can cause your cost of living to rise drastically over time.

Not only does high inflation hurt consumers, but it also hurts the entire economy. As a result, when goods and services become more expensive, people are less likely to buy them. Thus, aggregate demand declines, production and shipments decrease, and sales in stores decline. This affects everyone in the economy.

By employers

Besides being a measure of inflation, employers use the CPI to make wage adjustments that keep up with the cost of living. 

By investors

The Consumer Price Index is an important economic indicator for investors. An increase in the CPI affects retirees who are dependent on fixed annuities and pension plans. They will see the purchasing power of their income go down. However, equities such as Treasury Inflation-Protected Security (TIPS) are Treasury bonds that protect investors from the decline in the purchasing power of their money. Inflation can also create a lot of price volatility in the stock market, which can be bad for equities and investors. Long-term inflation predictions outside of healthy inflation (2%) can easily result in large sell-offs in the stock market.

By Government and the Federal Reserve for fiscal policy and monetary policy

Many often see the CPI as a measure of the effectiveness of government economic policy. For example, the Government (President and Congress) and the Federal Reserve use trends in the Consumer Price Index to help them decide on fiscal and monetary policies. As such, the federal income tax structure depends on CPI data to make adjustments in tax rates.  

To calculate other economic indicators and the purchasing power of $1

The Consumer Price Index and its components are also used to calculate and adjust the costs and prices associated with other government indicators, such as the GDP (Gross Domestic Product).

Finally, CPI data is used to calculate the purchasing power of a dollar. The government uses this information to adjust consumers’ income payments and to adjust income eligibility levels for government assistance. These automated cost-of-living wage adjustments are tied to CPI. They affect millions of Americans, including Social Security beneficiaries and military retirees. Another example of how the government uses the dollar’s purchasing power is adjusting the rates of other social benefit programs such as housing subsidies and food stamps.

What Does the Consumer Price Index Encompass?

Infographic that shows the 8 groups included in the Consumer Price Index.

As we mentioned before, the CPI is based on the price of over 80,000 goods and services and represents 87% of the country’s population. The Consumer Price Index does not represent those in rural areas or farmland, anyone serving in the military, and anyone currently in prison or a mental institution.

All of the goods and services that factor into the CPI’s index of 80,000 items can be broken down into 8 core groups:

  1. Food & Beverages
  2. Medical Care
  3. Transportation
  4. Clothing
  5. Housing
  6. Education
  7. Recreation
  8. Miscellaneous Items

Local sales tax rates are also part of the Consumer Price Index. However, other things that play little or no role in a person’s day-to-day life are not calculated. This includes things like the average cost of a life insurance policy or certain investments like stocks and bonds.

How to Calculate the Consumer Price Index?

Every month, the Bureau of Labor Statistics actually calls or visits various retail outlets and service providers all over the country to record current prices. They do this by calling and visiting commonly used establishments such as:

  • Grocery Stores
  • Internet Service Providers
  • Doctor’s Offices
  • Airlines & Train Stations
  • Car Rental Agencies
  • Storage Units

To calculate the CPI, the BLS first determines a base year. Then, the market cost of items for the base year is divided by the market cost of the items for the current year. Finally, this number gets multiplied by 100 to get the official Consumer Price Index.

The Different Types of CPIs and CPI Regions

Each newly published CPI will cover two types of calculations. The first one, known as the CPI-W, measures the Consumer Price Index for Urban Wage Earners and Clerical Workers. This index was used for households where more than half of their household income was from clerical and wage jobs. Until about 1978, this was the primary CPI factor. Today, the CPI-W is primarily used to help calculate Social Security benefits.

The second is the CPI-U which measures the Consumer Price Index for Urban Consumers. The CPI-U offers a more accurate representation of the general public as it covers about 87% of the country’s population. This calculation takes a look at all urban and metropolitan spending. It includes everyone, from people who work full time or are working for themselves, and those that do not have a job or whose earnings are below the poverty line.

The CPI is broken into four regions:

  • Northeast
  • Midwest
  • South
  • West

The CPI for some major metropolitan areas is published each month. Here are some of those areas:

  • New York
  • Los Angeles
  • Chicago

CPI Is More Helpful Than You Think

The Consumer Price Index is the most popular measure of inflation and cost-of-living changes. The government, the Federal Reserve, employers, consumers, investors, analysts, and many more use the Consumer Price Index. In addition, changes in the CPI and associated indicators predict what may happen in the financial markets and the economy. As a result, this information can be beneficial when making important decisions.

In addition, the CPI is used to adjust wages, social benefit programs, tax brackets, and other macroeconomic indicators. With all these applications and uses, it is clear that the CPI affects nearly all Americans and is an indicator to pay close attention to.

To get an idea of how inflation has changed over the years, you can use the CPI and inflation calculator from the Bureau of Labor Statistics.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.