What is the Consumer Price Index?

An unintended result of the ongoing financial crisis is the realization that, if there is one thing that the United States Government does better than spending (our) money, it's coming up with statistical surveys that it then converts into a bunch of numbers, known as "economic indicators," that purportedly reflect the economic "health" of the nation.

Since most Americans have a natural aversion to anything involving statistics, particularly statistics that are announced by their government, in the next few postings I'll explain (although probably not to everyone's satisfaction) what the three most commonly-cited "economic indicators" are supposed to mean. These indicators are the Consumer Price Index (CPI); the Unemployment Rate; and the Gross Domestic Product (GDP).

Let's start with the Consumer Price Index. But first, we need to correct a common misconception: the Consumer Price Index is not the same as the cost of living!

The cost of living is defined as the cost of maintaining a particular lifestyle and is thus specific to the geographic area where you live. As an example, the cost of living in San Francisco, CA is much higher than the cost of living in Tucumcari, NM. On the other hand, the Consumer Price Index is based on data obtained on the median cost of thousands of different products from many different areas of the country and thus is more sensitive to overall changes in prices over time.

The Consumer Price Index, or CPI, is computed monthly by a division of the Department of Labor known as (surprise! surprise!) the Bureau of Labor Statistics, or the BLS. The CPI was created in order to determine the overall yearly change in prices of consumer goods (actually a large number of goods known collectively as a "basket") due to inflation. This is accomplished by dividing the current price of the "basket" by the price of that same "basket" in the baseline, or index, period (which is the 36 consecutive months from January, 1981 to December, 1984) or, in mathematical terms:

CPI = (basket price (today) ÷ basket price (index period)) × 100

The "× 100" part of the above is for convenience in reporting, since it converts the result from a decimal expression to a whole number. Simply stated, if the CPI is reported to be 186.3 it means that it now costs $186.30 to purchase the same "basket" that would have cost (on average) $100.00 between 1981 and 1984.

A major criticism of the CPI, one with which the BLS will agree, is that the CPI tends to overestimate the rate of inflation. In 1995 the Senate ordered the creation of a special panel to study this question. This panel, usually identified as the Boskin Commission, subsequently determined that the CPI did indeed overestimate the rate of inflation by about 1.1% per year. In other words an inflation rate equal to or less than 1.1% per year is considered, from a statistical standpoint, to be zero inflation.

"But," you might ask, "Isn't the CPI just another number that no one pays any attention to?" To this question I would reply "You will be surprised how that number, the CPI, impacts our lives."

First of all, the CPI is a measure of long-term price stability. If the CPI rises sharply or, far less commonly, declines sharply, it is a sign that prices are unstable and that the economy may be heading for trouble. Since everyone is in favor of stable prices, it is to the incumbent government's advantage to maintain consumer prices at a reasonably stable level. To provide this stability the incumbents, who desperately want to avoid becoming the outcumbents, will then turn to the most powerful government agency in the history of the Republic: the Board of Governors of the Federal Reserve Banks.

By law (Title 12, United States Code, Chapter 3), the Federal Reserve is charged with the responsibility "to promote effectively the goals of maxi­mum employment, stable prices, and moderate long-term interest rates [emphasis added]." Its primary method of fulfilling these duties is through its control of the nation's money supply.

If the CPI is rising, the Federal Reserve will interpret this as a sign of inflation. Since inflation is the condition where the national economy is expanding "too fast" and there is more money available than there are goods and services to be purchased, the Federal Reserve will raise the interest rates that it charges banks to borrow from the Federal Reserve and thereby decrease the national money supply. This will, in turn, slow down (or even reverse) the tendency of prices to rise.

On the other hand, if the CPI is falling too rapidly the Federal Reserve can interpret this as a sign that the economy is in recession and it might respond by lowering the interest rates it charges the nation's banks in order to stimulate the economy by making more money available. Is the logic behind the Federal Reserve's recent cut in interest rates starting to make sense?

Your local bank or credit union also uses the CPI to help determine interest rates that they will charge for consumer loans. If the CPI is rising, the banks must charge a higher interest rate in order to compensate for the anticipated future inflation. Of course, as mentioned above, the banks' interest rates will also be influenced by the interest it must pay to borrow from the Federal Reserve.

Finally, the CPI is also the major factor in determining the annual Cost of Living Adjustment (COLA) to the benefits paid to recipients of Social Security or Civil Service retirement benefits or to those receiving state welfare assistance. If the CPI is rising, then Congress will approve a larger COLA to insure that the recipients' purchasing power will remain the same. Conversely, if the CPI is falling Congress will not be generous and the COLA will be smaller (since Congressmen want to be reelected, they will avoid not increasing the COLA or reducing benefits since doing either would amount to political suicide).

In conclusion, although they may seem to be the creation of a tribe of witchdoctors and a few dozen voodoo priests, government economic indicators are important factors in determining policies that will determine the future course of the nation's economy.

All we need to do now is to convince Congress to start paying attention.