If you are even a little bit interested in investing or macroeconomics, you have probably heard of the Consumer Price Index (CPI). People know it as the best measure of inflation, however they do not understand or learn about the nuances of what it is, how it is measured, and how it is used. Ultimately, the CPI represents the changes in price of all goods and services purchased by urban households. Yes. Urban households. Now, this is the vast majority of the United States population, about 93%, according to the Bureau of Labor Statistics website.
What is the CPI?
As stated above, the CPI measures the changes in price of all goods and services consumed by urban households. This basket of goods and services that comprise the CPI are weighted relative to the amount of an urban household’s budget that expense comprises. There are also multiple versions of the CPI: CPI-U, CPI-W, and C-CPI. The CPI-U is the CPI for all urban consumers, which is comprised of 93% of the population. The CPI-W on the other hand is the CPI for urban wage earners and clerical workers, this comprises of 29% of the population. Obviously, these do not add to 100%. This is because these measures are not exclusive, you can be a part of both, only one, and neither of them, so the amount of the population they measure is irrelevant. It is important to note that there are more categories in each of these measures. For example, the CPI-U also includes the expenditures of professional, managerial, and technical workers, self-employed, short-term workers, unemployed, retirees and others not in the labor force. Makes sense why it includes 93% of the population. However, the CPI-W only includes the expenditures of those in hourly wage earning or clerical jobs.
Another version of the CPI I would like to cover is the Chained CPI (C-CPI). This measure includes weights for goods and services that are “more current” than the other two measures because they use updated expenditure surveys. Hint, this is the one you hear about in the news. The whole “Consumer price inflation for the year 2021” came from the C-CPI. The C-CPI also involves changes in relative prices. The example the BLS gave is the prices of beef and chicken. If the price of beef increases without the price of chicken increasing as well, the C-CPI assumes consumers will start to purchase more chicken instead of beef and adjusts accordingly. This is meant to reflect current consumer behavior as accurately as possible. The final difference between the chained CPI and its counterparts is in its reporting. The C-CPI is subject to four quarterly revisions and isn’t considered final until all four quarterly revisions are complete. On the contrary, the CPI-U and CPI-w are considered final once they are published.
How is the CPI measured?
We have already talked a little bit about how the CPI is measured by talking about the different population groups that are used to calculate the various versions. However, I want to get some actual numbers because I am a nerd. According to the BLS, there are 75 urban areas throughout the country that are used to calculate the CPI. I didn’t find which ones, but its probably there, you just have to go on a treasure hunt for it like every other government website. They also receive these prices of goods and services from about 23,000 retail and service establishments within those 75 urban areas. Also, remember that the CPI is the change in price of all goods and services consumed in urban households, the actual figure that is released (the percentage, i.e., 7% for 2021) is the weighted average of all those goods and services where the weights are derived from the reported expenditures on each item as established by the consumer expenditure survey.
How is the CPI used?
Since the CPI is a measure of the changes in prices of goods and services consumed by urban households, it is generally used to measure inflation. Remember that it measures the CHANGE in prices, it is just that consumer prices have been increasing basically every year for the past few decades and people have just expected this to continue.
One of the ways the CPI is actually used is as a measure of government (fiscal) policy. Since it is a measure of consumer prices, it can be significantly influenced by policy because if the government implements any kind of policy that effects price signals, it will show up in the CPI, at least at some point because it lags, meaning the effects of the government policy may take 6 to 18 months to manifest in the indicator.
Another way the CPI is used is to adjust other economic series for price changes. This translated the series into “inflation-free” dollar terms. Since inflation is a real problem in an economy, private and public entities must be aware of it so that their workers will not be affected majorly in their standard of living. Examples of this are social security and the income tax structure. If inflation is high, retired people on social security will not be able to buy the same amount of goods and services as before because the prices of those goods and services are increasing faster than their social security checks. As for the income structure, if the tax bracket does not keep pace with inflation, then people will find that their income will increase (only nominally) along with inflation and place them in a higher tax bracket. Their purchasing power (the amount of goods and services they can purchase) has not increased, just the nominal number of their income, but Uncle Sam would be taking more out of their pocket. Now, these are just public sector examples.
There are places where the CPI is used in the private sector as well. Businesses and private firms will use the CPI to keep rents, royalties, alimony, child support and other payments in line with the change in prices. You don’t want inflation to steal your purchasing power from you, well, neither do businesses. Also in unions, workers can be covered by collective bargaining agreements that would tie wages to the CPI. Over 2 million workers are covered by these collective bargaining agreements, so the CPI can be considered rather important, especially for those workers and their families.
Commentary and Conclusions
Surprise surprise, the CPI is rigged. Especially with social security being tied to the CPI, the government has massive incentive to downplay and modify the CPI so that it is calculated to be lower. It is known that the government does this. For example, Owner’s equivalent rent of residences is almost 25% of the CPI in terms of weighting. The December 2021 Year over Year for “owner’s equivalent rent” was printed at 3.8%…. I’m going to call bull on that because I am currently trying to find my first apartment after college and that isn’t even remotely true. Also, if you look at Zillow or other housing services that track home prices that are actually being sold, they tell a much different story. Zillow recorded an increase of 19.6% over 2021. That is over 5 times the government stated increase. Owner’s equivalent rent is basically the government asking some homeowners how much they would rent their house for. If these homeowners aren’t landlords, how are they going to know? We can tell they don’t by the massive spread in the numbers. I just wanted to give you guys an example on how the CPI is cooked to be lower because this makes the government’s life easier due to their debt load. Unfortunately, this comes at the expense of your purchasing power and standard of living.
To your wealth and future,
James Forsythe
Here is a PDF of the CPI-U from the BLS website
For more on inflation
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