Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Measuring inflation: the Consumer Price Index

The January inflation report released last week showed that while progress continues some prices remain stubbornly high, signaling that the Fed has more work to do. The Consumer Price Index for all urban consumers rose by 6.4% in January over the same period in 2022. That compares with 6.5% in December and down sharply from the 9.1% reported last June, but still a long way from the central bank’s 2% target.

While there are several different gauges of inflation, the CPI is by far the most familiar and widely used index to measure prices, adjust income payments like Social Security, and recalibrate tax brackets and retirement contribution limits. Given its importance to virtually every American, it helps to understand a little about how the CPI is constructed.

The earliest efforts to collect price data in the US began with the creation of the Bureau of Labor in 1884, tasked with conducting an analysis of family expenditures and retail prices. The first study concluded in 1890 and established the infrastructure to support systematic income and price measurement. In response to rapidly escalating inflation as the US entered the Great War in 1917, the Bureau expanded its collection efforts and refined its methodology, producing the first “cost of living” index for 32 individual cities in 1919. In 1921 the agency, now known as the Bureau of Labor Statistics, began publishing a national price index, the forerunner of the current CPI.

The computation of the monthly Consumer Price Index is a monumental task. The work begins with the specification of a market basket of representative goods and services that consumers typically buy, based upon a survey of 36,000 households. The market basket contains individual items from 200 categories summarized into 8 broad headings like food and beverages, medical care, housing, and transportation. 

Next the BLS collects around 94,000 separate prices for goods and services from 75 urban areas each month, with about two thirds obtained in person by visiting brick-and-mortar stores and the rest by telephone or website.

In addition to the goods and services survey, the BLS compiles rent information for around 8,000 individual residential units to estimate shelter costs. Owner occupied houses are not considered retail expenditures but rather as capital investments and are excluded from the index. However, to incorporate the impact of owner-occupied units, BLS includes a measure called “owner’s equivalent rent” that is an estimate of what the homeowner would pay to rent the property.

Each of the spending categories is weighted to reflect their relative importance to an average family. For example, since housing comprises the largest single expenditure from most households, the shelter component represents 33% of the CPI, while food makes up 14%.

In addition to the item weightings, BLS also weighs geographically to account for price differentials in different areas. Then, certain adjustments are then applied to the data. For instance, the Bureau makes systematic corrections for “shrinkflation” when your roll of Charmin is reduced by 20 sheets. There is also an adjustment for changes in quality or performance reflecting increased utility or substitution of materials over time. Example: a 2023 Ford F-150 pickup has nearly three times the horsepower and double the gas mileage of the 1982 version so the index price is modified to reflect enhanced capability.

This massive trove of data is then combined according to the weighting factors into a single index for the aggregate price level, compared to a defined base period (1982-1984) for which the index value is set to 100. The value of the CPI just released was 300.5, meaning that across the economy the price of a $100 item in 1984 is now over $300 on average.

And they do this every single month.

Economists recognize that prices for certain items are highly volatile from month to month. For example, gasoline at the pump and egg prices fluctuate much more in the short run than rent. Therefore, BLS also calculates a “core” CPI, excluding food and energy. Core CPI rose by 5.6% over the past 12 months, the smallest annualized rate since December 2021. Core measures are useful in gauging trends over time by filtering out monthly noise.

While the CPI is the most familiar and most frequently used index, other inflation metrics exist that attempt to address some shortcomings of the CPI. The Federal Reserve prefers a measure called the Personal Consumption Expenditure or PCE index produced by the US Bureau of Economic Analysis (BEA). While CPI consists only of direct spending by households, PCE includes indirect expenditures like third party payments from insurance companies to healthcare providers on behalf of consumers which do not show up in CPI. PCE represents a broader sampling and is less sensitive to shelter price changes and more responsive to healthcare costs. Nevertheless, CPI remains the de facto benchmark in most practical applications and in the public imagination.

Following a sharp spike in 2022 due to Covid demand and supply chain bottlenecks, goods inflation is now coming down rapidly. TVs and used cars for example are 11% cheaper than last year. A tougher nut to crack is inflation in services, which still enjoy strong demand and make up nearly 60% of the index. Housing costs are up 7.9% and airfares are 26% higher.

It is essential for many reasons to defeat the recent price spiral. But in order to whip inflation, one must first know how to measure it.

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