How to Measure Inflation – The 3 Flavors of the Consumer Price Index (CPI)July 20th, 2012 by David Waring
Inflation is the upward change in price over time. Deflation is the downward change in prices over time. Inflation is very common, and when low, considered part of a healthy economy. Deflation is very rare and considered a sign of an unhealthy economy. Most economists consider an inflation rate of between 1.0% and 3.0% to be a healthy level of inflation.
When I was a child, I could buy a Nestle Crunch bar for $0.45. Now, the same candy bar costs around $0.75 cents. The rate of inflation for that candy bar from my childhood to now is 67%. However, normally we measure changes in inflation on either a monthly or annualized basis.
Normally you would not measure inflation for just a candy bar. While a candy bar might be part of my spending, it not a big part of my spending, and the prices of other things that I spend my money may be increasing at a slower or faster rate than candy bars. This brings us to the big question regarding measuring inflation: What do we include in the basket of items which we use to measure inflation and how do we weight them?
CPI – U
The most popular measure of inflation is the Consumer Price Index For All Urban Consumers, the CPI-U for short. Normally when people talk about the CPI they are talking about the CPI-U. The goal of the CPI-U is to measure changes in the cost of living for all people living in a non-rural, city environment. CPI-U is very important in the financial markets for two reasons:
- There are bonds issued by the treasury (TIPS) whose value is directly linked to CPI-U.
- One of the mandates of the Federal Reserve is price stability, which is generally interpreted as keeping CPI-U around 2.0%.
You can see a chart of the CPI-U and inflation since 1946 here.
You may also hear the term Core CPI, which is CPI-U excluding food and energy prices. Food and energy prices tend to be much more volatile than the rest of the goods and services included in the CPI-U and subject to more temporary shock.
CPI – W
Headline and Core CPI tend to be reported on the news, however the CPI-W is more important to retirees than these two measures of inflation. The Social Security Administration bases the automatic cost of living adjustments (COLA) increases for social security recipient on CPI-W, which is the Consumer Price Index For Urban Wage Earners and Clerical Workers. Basically, CPI-W excludes the spending habits of the well-off and the poor.
CPI data is collected, calculated and released by the Bureau of Labor Statistics, which is part of the US government. The data is released around the middle of the month at 8:30 AM EST for the previous month and you can find the releases here.
Historical Chart Of CPI (changes year to year) Since 1992
Blue Line – CPI – U
Red Line – CPI – U Excluding Food and Energy
Green Line – CPI -W
As you can see from the graph, CPI-U and CPI-W are almost identical. For the most part, CPI-U has increased by between 1.5% and 3.5% for the last 20 years. The major exceptions were just before the financial crisis where CPI was running at 4.0% and during the crisis where CPI dropped into negative territory.
However, food and energy prices were a leading cause of inflation from 2003-2008 and deflation in 2009. Taking out food and energy, since 1994 core inflation has been in a range between 1.0% and 3.0%. (According to this data it looks like the FED has been very good at keeping price stability.)
Major Criticisms of CPI
Many people use estimates of CPI to plan how much income they will need for retirement. However, CPI is not designed to accurately reflect price increases experienced by senior citizens. In particular, medical and insurance expenses make up a larger proportion of the spending of senior citizens than for the general population. Over the last decade or so, medical expenses have risen at a dramatically higher rate than inflation in general. While this might change due to the Affordable Care Act (Obamacare), projecting retirement expenses using CPI to estimate future prices might lead one to severely underestimate one’s income needs.
Other problems with CPI include
- Does not accurately reflect the costs related to owning a home. The CPI estimates estimates the cost of homeownership by estimating how much you would have to pay if you were renting your house. The problem is this does not include all the costs involved like property taxes, maintenance etc.
- The basket of goods and services only gets updated once every 10 years. For example, at a point in time when over 40 million people used cell phones, they weren’t part of the list.
- Doesn’t include the substitution effect. As goods get expensive, people use less of them. As they get cheaper, the reverse. The basket is fixed and doesn’t adjust for this substitution bias towards cheaper substitutes.