What Does CPI Actually Measure?February 22nd, 2012 by The Financial Lexicon
The Consumer Price Index (CPI) is widely known as the government’s measure of inflation. The Federal Reserve defines inflation as “a general increase in the overall price level of the goods and services in the economy.” It is important to note that there are many different official measurements used to capture inflation, including the Producer Price Index (PPI) and Personal Consumption Expenditures (PCE) as well as multiple Consumer Price Indexes, including the CPI-U, C-CPI-U, CPI-W, and the so-called “Core CPI.”
According to the Bureau of Labor Statistics (BLS), the Consumer Price Index can be defined as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” On the website of the BLS there is a copious amount of information concerning the CPI. I would like to provide some of the more relevant information in order to help investors come to their own conclusions about how relevant the CPI is compared to their own personal spending experiences.
The CPI attempts to capture the spending patterns of two groups: all urban consumers (roughly 87% of the U.S. population) and urban wage earners and clerical workers. From the “all urban consumers” group, the BLS computes the CPI-U and the C-CPI-U. The CPI-W comes from the “urban wage earners and clerical workers” group. This group represents roughly 32% of the U.S. population and is a subset of the CPI-U. What about the other 13% of the population? The CPI does not capture the spending patterns of people living in rural areas, members of the Armed Forces, and individuals living in institutions.
Furthermore, the BLS points out that the CPI is not a pure cost-of-living index, as it doesn’t take into account changes in “governmental or environmental factors that affect consumers’ well-being.” One example of this is income taxes paid by individuals.
In terms of what it measures, the CPI includes a myriad of items organized into eight major categories: Food and Beverage, Housing, Apparel, Transportation, Medical Care, Recreation, Education and Communication, and Other Goods and Services. Every month, representatives for the BLS call thousands of businesses/establishments all over the country to obtain information on the prices of roughly 80,000 items. Prices are then compared to the average price level for the 1982, 1983, and 1984 time period (the “reference base”).
Which of the various CPIs is the one often cited by the media? That would be the CPI-U. However, the so-called “Core CPI,” officially known as the “All items less food and energy” is another measure often cited in the media.
It is important to note that no one measure of inflation is perfect for all households living in the United States, and therein lies an opportunity for investors. Remember that the CPI represents an average. Depending on where you fall within the spectrum of prices across the various regions of the United States, yields on fixed income products will have a different meaning to you. What may be a negative real interest rate for one household might not be for another. What may be a nice yield spread to your personal inflation rate might not be for another. Furthermore, given that the principal for Treasury Inflation Protected Securities (TIPS) is adjusted according to the CPI (which represents an average), one investor might find the price at which TIPS are trading to be a great deal while others might not. It all depends on your personal inflation rate and its relation to the national average represented through the CPI.
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