Consumer Price Index (CPI): Understanding Inflation's Impact on Your Wallet

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Investors closely monitor the forecast for Consumer Price Index as an indicator of actions that may be taken by the Federal Reserve. Oscar Wong/Getty Images

• The Consumer Price Index (CPI) measures inflation by comparing the change in price over time for a basket of consumer goods and services.
• The CPI illustrates the effectiveness of government economic policy and influences financial decision-making throughout the economy.
• While the CPI is widely followed, it is more representative of urban populations while excluding rural populations and some geographic regions.

Inflation is a word that's in the news frequently, and it's a word that makes people nervous. When prices for goods like food, clothing, and gasoline are on the rise, consumers fear that the purchasing power of their dollars is declining.

Inflation is an unavoidable part of economic growth, but it can be measured and managed to maintain a healthy economy. This is why it's important to understand what the Consumer Price Index (CPI) is and how it ties into inflation.

What is the Consumer Price Index?

Definition 

The CPI measures the average change in prices that urban consumers pay for "a market basket" of goods and services over a specified period. This market basket includes a wide range of expenses that are part of everyday life, for example costs associated with food, housing, health care, transportation, and energy use.

The CPI uses the average price changes for an established basket of goods and services to demonstrate price trends within the economy. An increase in the value of the index offers a quantitative measure of inflation, or the decline of the dollar's purchasing power over time. Aside from eroding consumer purchasing power, inflation can be very worrying because it means that savings will be worth less in the future.

Purpose 

The Bureau of Labor Statistics (BLS) describes the CPI as "the most widely used measure of inflation." Many businesses harness this key economic indicator to help project expenses and budget, while investors use the information to determine required returns and inform investment decisions. It also provides a barometer to aid the government in managing the economy. Changes in the CPI affect almost everyone in one way or another.

The CPI market data is developed from expense information collected from the Consumer Expenditure Survey (CE) program that's sent out on a quarterly basis. It's a national survey conducted by the U.S. Census Bureau on behalf of the BLS and collects data needed for the calculation of the CPI. It's been around since 1980.

Quick tip: By following the CPI, consumers can understand how inflation is impacting their purchasing power and make financial decisions accordingly.

Published by the Bureau of Labor Statistics

The BLS publishes CPI information every month, which gives market observers regular data they can use to gain greater insight into the health of the economy.

Note: There are two separate surveys in the Consumer Expenditure survey: the quarterly interview survey and the diary survey. The quarterly interview asks household respondents about the costs of large purchases (car, house) and regular expenses (rent, utilities). The diary survey asks survey respondents to keep two one-week diaries recording all purchases to capture small purchases like food, meals, and gasoline.

How is the Consumer Price Index calculated?

Rachel Mendelson/Insider

Market basket of goods and services  

The Bureau of Labor Statistics (BLS) reports the CPI on a monthly basis, and also breaks down CPI by region. CPI is calculated for the Northeast, Midwest, South, and West, as well as the New York, Chicago, and Los Angeles metropolitan areas.

Many different expenses serve as components of the CPI. As a result, the market basket that is used to calculate this key economic indicator consists of a wide range of costs that consumers incur on a regular basis.

"The BLS reports index weights for dozens of categories, subcategories and specific items in the CPI's basket of goods and services," noted an article published on the website of the Pew Research Center. "The biggest category by far is shelter, which accounts for nearly a third of the index," it emphasized. Interestingly enough, the CPI also accounts for something called lodging away from home, for example stays in hotel rooms.

The second-largest component is food costs. This includes expenses for food that is purchased to be eaten at home and also visits to restaurants.

Another part of the market basket used to determine the CPI is energy expenses, which consist largely of gas prices. The cost of gas decreased during the pandemic, as demand lowered, but this desire for this fuel rose as the economy went back into business.

The vehicles that consume gasoline are also accounted for in the market basket used to determine CPI.

Price collection 

The BLS gathers information to determine the price of its market basket by gathering data from a wide range of households and retail establishments. The government agency provided some specific detail in a statement released in June 2024:

"Prices are collected each month in 75 urban areas across the country from about 6,000 housing units and approximately 22,000 retail establishments (department stores, supermarkets, hospitals, filling stations, and other types of stores and service establishments)," the release stated.

"Prices of most goods and services are obtained by personal visit, telephone call, web, or app collection by the Bureau's trained representatives," the document noted.

Weighting 

When calculating the price of a market basket, each individual component expense is assigned a weighting based on how much it contributes to overall spending. The government periodically adjusts these weights to correspond with the changing behaviors of consumers.

In 2022, the BLS announced that starting the following year, it would adjust these weights on an annual basis.

"Starting with January 2023 data, the BLS plans to update weights annually for the Consumer Price Index based on a single calendar year of data, using consumer expenditure data from 2021," the government agency stated. "This reflects a change from prior practice of updating weights biennially using two years of expenditure data."

How does the CPI affect you? 

Purchasing power 

The CPI is indicative of the rising price level, which plays a key role in the purchasing power of individual consumers. An increase in the value of the index offers a quantitative measure of inflation, or the decline of the dollar's purchasing power over time.

However, when the CPI index value declines, consumer prices are falling over time and the purchasing power of the dollar is increasing. This is known as deflation. While falling prices sound like a good thing, deflation can indicate an impending recession.

"The CPI is important to the average person as it makes it possible to compare the increase in the average price level to the increase in wages," says Dr. Peter Westin, adjunct professor of finance at DePaul University and founder of Stratonomics. "If consumer price inflation exceeds the increase in the average wage, real wages are declining." Consumers can clearly see the impact of inflation on the purchasing power of the dollars they earn.

Quick tip: By following the CPI, consumers can understand how inflation is impacting their purchasing power and make financial decisions accordingly.

Cost-of-Living Adjustments (COLAs) 

Cost-of-living adjustments (COLAs) can affect the financial well-being of everyday consumers in many different ways, as these adjustments can influence wages, Social Security benefits and pension payments.

These adjustments are frequently based on how much prices have gone up, which is measured by changes in the CPI.

The Social Security Administration's website reveals how a specific measure of CPI can impact these adjustments. "According to the formula, COLAs are based on increases in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W)," the website states.

Financial planning 

The CPI, as a proxy for inflation, can impact many different aspects of financial planning.

Retirement planning, for example, can be impacted significantly by changes in this inflation measure. Not only does the CPI impact the required rate of return on retirement savings, but it's a necessary component in estimating income needs in retirement.

When it comes to broader investment planning, the CPI is also a key consideration. The CPI is important to investors for many reasons, as the rate of inflation can have an impact across financial markets. Rising inflation rates can have a negative impact on bond values, and it's very damaging to those who receive pensions or annuity payments.

Rising inflation also impacts the stock market. When inflation rises beyond a comfortable level (2%, as a rule of thumb), the Federal Reserve may take steps such as raising interest rates to slow the economy.

Operating a company in a rising rate environment becomes more expensive, earnings decline, and stock prices fall. However, stock performance by sector may vary.

"Investors will be concerned about inflationary expectations more than the current inflation level," says Westin. "For example, if the outlook for inflation deteriorates, investors may want to reposition their portfolio in order to take advantage of inflation."

Historically, energy, real estate, and consumer staples have tended to outperform in periods of higher inflation while tech stocks and materials have tended to underperform. However, and most importantly, investors are closely monitoring the forecast for CPI as an indicator of actions that may be taken by the Federal Reserve.

The inflation outlook is also an important consideration for investors in establishing a required rate of return. Since inflation reduces the purchasing power of money over time, desired investment returns must take this into account. The longer an investor's time horizon, the more important the inflation outlook becomes.

The return an investor receives on an investment or portfolio is the nominal return. However, this rate of return is not adjusted for inflation. By using CPI inflation rates, this return can be adjusted to take inflation into account, yielding the real rate of return. An investor's required return should always be the real rate of return to account for the negative impact of inflation on investment values.

Quick tip: The CPI is one of the most watched economic indicators and can influence everything from wages and salaries to social security and government benefits. It can even portend changes in economic policy.

Types of Consumer Price Indexes 

A handful of types of CPI are calculated in order to provide a more comprehensive level of data on inflation.

CPI-U 

CPI-U is calculated for All Urban Consumers and incorporates more than 90% of the U.S. population. It offers a more representative view of the overall population and is consequently more widely used.

CPI-W 

CPI-W is calculated for Urban Wage Earners and Clerical Workers. It is based on households in which income is more than 50% derived from clerical or wage occupations. The BLS estimates that this measure incorporates approximately 30% of the population.

Chained CPI (C-CPI-U) 

In 2002, the BLS created something called the Chained CPI (C-CPI-U) in order to account for how substitutions impact the cost of living. A post on the website of the Congressional Budget Office provides additional detail on this matter:

"The chained CPI-U provides a more accurate estimate of changes in the cost of living from one month to the next by using market baskets from both months, thus 'chaining' the two months together," the post clarifies.

Criticisms of the CPI 

In the 1990s, Fed Chairman Alan Greenspan testified in front of Congress, claiming that the CPI overstated price increases by between 0.5% and 1.5% every year. As a result, the Senate Finance Committee put together a group of economists to study this matter.

Substitution bias 

Some have claimed that the BLS overstates how much the CPI increases by failing to account for consumers substituting one good for another when prices increase. In other words, if the price of one good rises in price, consumers will frequently swap it for another item that is simply less expensive.

The failure to account for this when calculating CPI has been called substitution bias. "A fixed market basket measure like the CPI assumes that, contrary to standard economic theory, consumers do not substitute Big Macs for Whoppers when the price of one rises relative to the other," an article on the Federal Reserve Bank of St. Louis website explains.

Quality changes

While the market basket used to calculate CPI measures the prices of items, it does not measure how quality can change over time. While the cost of many different items used in everyday life has gone up, their quality may have also risen.

"New and improved products often cost more because of their enhanced features. In theory, however, such improvements should not count as a net price increase to the consumer," the aforementioned Fed article notes.

New product bias 

Another criticism of the CPI is that its measure of changes in the cost of living may not fully reflect the impact of new products that become available in the market, as the price of these products may be incorporated into the market basket long after they enter the market.

Consumer Price Index FAQs 

What is a good CPI rate? 

Moderate inflation is considered healthy for the economy, with the Fed ideally aiming for a price level that increases 2% per year.

How does the CPI affect interest rates? 

Fed officials frequently rely on the CPI when determining whether they will lower or raise the benchmark federal funds rate, which in turn has an impact on broader interest rates.

Where can I find the latest CPI data? 

CPI figures are widely shared, but if you want a primary source, go right to the BLS website, which produces these figures.

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