Consumer Price Index

What It Means

The Consumer Price Index (CPI), one of the most important economic indicators in the United States, measures the change in prices that consumers pay for goods and services from year to year. This figure tracks inflation (a general rise in prices) or deflation (a fall in prices). A large increase in the CPI over a short period of time represents growing inflation, and a drop in the CPI signifies deflation, both of which can be harmful to an individual’s finances and a nation’s economy. Generally speaking, moderate and steady yearly inflation rates indicate a stable economy. When prices change rapidly, it usually means that the economy is in trouble. Because erratic price shifts can have such a devastating effect on the economy, the U.S. government takes extensive measures to chart, or figure out, the Consumer Price Index.

Consumers pay close attention to this figure as well. Because the CPI dictates the yearly income for many Americans whose wages rise according to the annual cost of living increase, it is one of the most closely scrutinized of all the economic indicators (statistics that reflect the health of the economy). Economists estimate that the CPI affects the earnings of approximately 2 million union workers, the payments to almost 50 million people on social security (federally sponsored financial benefits, including disability income, military veteran’s pensions, and public housing assistance), the value of food stamps for 20 million recipients, and the cost of school lunches for more than 25 million children.

When Did It Begin

The United States began charting price changes in 1893. The figures derived from these calculations became increasingly important at the beginning of the twentieth century with the growth of labor unions (workers’ organizations that bargain for their members’ wages, benefits, and working conditions). Business owners and union leaders relied on this information to negotiate wage increases that were in step with inflation. After World War I (1914–18) U.S. policymakers realized that a more accurate system would be necessary to monitor the staggering fluctuations of the wartime and postwar economies; thus, in 1919 the Bureau of Labor Statistics began calculating the CPI, extending their research back to 1913, the year before the war started.

In the 1930s, when Keynesian economic theory (which calls for government intervention to stabilize the economy) started to displace laissez-faire economics (trade without government control or interference) in the United States, government economists began to rely more heavily on the CPI to establish economic policies, including tax rates. Later, as government efforts to control inflation depended increasingly on monetary policy (managing the amount of money in circulation), the CPI was also an important measure. If the CPI indicated that prices were rising too quickly, the Federal Reserve (the U.S. central bank) increased interest rates (fees charged to borrow money) in order to curb spending and bring prices back down to more reasonable levels. In contrast, economic declines and fears of deflation led the Federal Reserve to do the opposite, lower interest rates, in order to encourage consumer spending and, in turn, to bring prices back up. Since its inception, the CPI has remained one of the most reliable indicators of the health of the country’s economy.

More Detailed Information

In the United States the CPI is determined by the U.S. Department of Labor’s Bureau of Labor Statistics (BLS), which surveys the spending habits of American families and monitors retail prices throughout the country. A team of BLS field representatives visits 24,000 to 29,000 American families per month to conduct interviews and compile data on the items they buy. Participants are also asked to record their purchases in diaries. In addition, the BLS charts the cost of approximately 90,000 goods and services in more than 20,000 retail stores in 85 representative cities. The survey covers most commonly purchased everyday products and services, such as shoes, motor fuel, produce, medical care, washing machines, and automobile repairs. Results are compiled monthly and published the second week of the following month on the BLS website. For example, the CPI for March 2006 would be posted by April 15, 2006.

Calculating the CPI is more complicated than merely monitoring price changes. To figure out what average Americans spend in a month to meet their daily needs, the BLS separates goods and services into eight categories: food and beverage, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. A computer program is then used to compile a fixed set, or “market basket,” of representative items drawn from each of the categories.

Each month the BLS publishes the CPI as a percentage increase or decrease of the average cost of the market basket. A typical monthly BLS bulletin might read as follows: “The CPI for American consumers rose 0.2 percent in February 1998.… For the 12-month period ending in February, the CPI has increased 1.7 percent.” This would mean that the average cost of goods (or cost of living) for Americans is 0.2 percent higher than it was in January and 1.7 percent higher than it was the previous year.

To make this index more meaningful for specific groups of Americans, the BLS publishes numerous CPIs. The two main figures are the CPI-U (Consumer Price Index for All Urban Consumers) and the CPI-W (Consumer Price Index for Urban Wage Earners and Clerical Workers). These two measures divide Americans according to their income, with the CPI-U being the higher of the two income brackets. There is also a separate index for each of the 26 major metropolitan centers and 4 geographic regions in the country. One of the primary weaknesses of the system is that the BLS collects data only in urban areas, and the CPI therefore does not accurately reflect pricing in rural areas. Nevertheless, the CPI is believed to be a reliable economic indicator for 87 percent of the population.

Recent Trends

In the United States the CPI has increased between 1.6 and 3.4 percent per year from 2000 to 2006. The lowest rate of increase (1.6 percent) came between 2001 and 2002. Twice between 1999 and 2006 (from 1999–2000 and from 2004–5) the country saw inflation rise 3.4 percent. During this time costs for medical care increased by about 4 percent per year, while costs associated with housing rose by 2.5–4 percent annually.

The greatest increases in this period were in the cost of motor fuel. For example, from 1999 to 2000 the cost of motor fuel increased 28.4 percent, and from 2004 to 2005 gas prices rose another 22.2 percent. Consumers also paid steadily more for utilities, such as water and electricity, with a 10.6 percent increase from 2004 to 2005 and typical increases ranging between 7.5 and 8.5 percent. A notable exception occurred in 2002, when utility prices dropped by 6.1 percent compared to 2001. There have been only moderate increases in costs for food (about 2.5–3 percent annually), and clothing costs decreased between 2000 and 2006 by about a half percent a year.