Have you ever noticed how the price of everyday items fluctuates over the years? Are you curious how these prices are determined? The consumer price index (CPI) is the most widely used indicator of inflation in the United States and Canada. Changes in the CPI are used to assess price variations associated with the cost of living. In this article, we’ll break down why the CPI is important and how it impacts consumer spending.
What is the Consumer Price Index (CPI)
The CPI serves as a method of measuring the average price changes of common goods and services over time. The CPI is a measure that examines the weighted average price of a fixed basket of goods and services. The price of each item in the basket is evaluated on a regular basis.
The CPI is calculated by taking price changes for each individual item in the predetermined basket of goods and averaging them. The evaluation is used to track inflation. For example, if the price of the basket of goods increases 1% in a year, inflation is said to be at 1% that year.
What is in the basket of goods and services?
The fixed basket of goods represents the purchasing patterns of consumers. Today, items like record players or DVDs would be replaced by smartphones and tablets. The basket is generally broken down into eight categories:
- Housing
- Apparel
- Transportation
- Food and Beverages
- Medical Care
- Recreation
- Education and Communication
- Others
These items are often evaluated and updated to ensure they truly represent consumer trends. Retail outlets across the country help determine this information. And official governing bodies, like Statistics Canada and the U.S. Bureau of Labor Statistics (BLS) help conduct interviews and outsource this administrative data.
Housing and the CPI
Housing is an important component within the index. This includes rental costs, owner-occupied housing, hotels, inns, and other forms of lodging. Currently, shelter makes up nearly a third of the basket for CPI inflation in the US, and therefore, the smallest increases in rent and home prices can greatly affect inflation rates.
And while shelter is a major component of the CPI, house prices are not included in the overall index. House prices are seen as expenditures on an existing asset, where increases in price will benefit the homeowner. However, rent is included in the CPI, because rent is a current expense for consumers, and rising rent is a financial obstacle.
This can be a challenge for economists.
With owner-occupied homes, the price reflects both its value as an investment asset (which is ignored by the CPI) and as a service to renters (which is included by the CPI).
Because the index sees owning a home as an asset, rather than an essential that doubles as an investment, younger generations are struggling financially when trying to purchase their first home. This discrepancy is delaying the overall financial stability of young adults, and is a cause for concern.
Calculating CPI
The formula used to calculate the CPI for a single item is as follows:
CPI = Cost of market basket in a given year / Cost of market basket in base year X 100.
The base year is a benchmark number used to assess changes over time. In the US, this number is determined by the BLS.
Limitations of the CPI
While the CPI is important in assessing economic trends, it has a few key limitations. The index evaluates eight major categories of consumer spending; however, it fails to take into account other factors that impact the cost of living in a given area; such as social or environmental causes.
Situation bias is another key concern many have with the CPI. The way the index functions, it ignores the presence of substitutes in the market. For example, if the cost of butter increases, many consumers may switch to margarine—substituting more expensive goods for cheaper alternatives. However, the CPI assumes that people will continue to buy the more expensive butter. And as a result, the reported increase in the cost of living is higher than the actual increase, skewing the numbers entirely.
While the CPI accounts for those in urban areas, where a vast majority of consumer spending occurs, it does not take into account those living in rural areas. Therefore it cannot truly represent the entire population.
Why is understanding the CPI important to Consumers?
Conclusions from the CPI can be used to understand other changes in the economy. For example, increases in minimum wage are often the result of changing patterns noted by the CPI. The index is an important part of the economy as it automatically provides the cost of living wage adjustments.
For example, the US CPI for All Urban Consumers: Meats, Poultry, Fish, and Eggs, suggests that in August 2021 the average cost of these household groceries is around $287; however, 20 years ago, in August 2001, the average cost was around $162. Having this information gives employees the data necessary to fight for increased wages.
According to the BLS, the index can also impact eligibility for certain levels of government assistance. The CPI is often also used to adjust consumers’ income payments and determine Social Security benefit amounts.
On an individual level, understanding these changes can help a consumer recognize their own purchasing power—the value of a currency expressed in terms of the amount of goods and services that one unit of money can buy.
Increased inflation results in decreased purchasing power, and can impact long-term savings, investments, and budget plans.
Importance of the CPI as seen through housing
For example, according to research conducted by the U.S. Bureau of Labor Statistics, housing that would cost $100,000 in the year 1967 would cost $902,981.73 in 2021 for an equivalent purchase. Therefore consumers can see that prices for housing were 802.98% higher in 2021 compared to 1967.
In 1967, the federal minimum wage in the US was $1.40. As of 2020, the minimum wage stands at $7.25.
Therefore, consumers can see that despite there being an 800% increase in housing prices, the minimum wage has only increased 417% in the same time frame.
Conclusion
The CPI in the simplest terms, is a cost-of-living index. It was designed to help governing bodies and individuals measure the price of different goods and services consumed within a household. It is not meant to measure the value of investment assets that families hold. Because of this, the CPI considers the cost of rent within the index, but fails to account for the rising cost of homes. Thus, making it more difficult for younger generations to purchase their first home.
Understanding the changing dynamics within the CPI and inflation can shed light on the importance of consumer purchasing power, investing and protecting assets like land and property.
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