Understanding CPI | AIER

The Consumer Price Index (CPI) is the most well-known and widely used measure of price in the United States. This index is prepared monthly by the Department of Labor for the 32 largest cities in the United States. Although it ignores rural value, it still covers 90% of the US population. Annual percentage change in CPI is the most widely used measure of inflation. Until recently, inflation was under control in the United States, but in some other countries it was much higher. In Zimbabwe, for example, in 2008, prices doubled every day. Most recently, Argentina, Turkey, Russia and Venezuela have also experienced severe devaluation of their currencies. High inflation can significantly damage the performance of an economy, to the extent that economic policymakers claim a low and stable rate of inflation as one of their main objectives.

Origin of CPI among the researchers of the Department of Labor in 1919. The Department of Labor wanted a measure of consumer value to explain their already collected wage data. The initial choice of which food items to include in 1888 was unscientific, as researchers simply went home and asked their wives what they bought each month. The 1919 product basket was chosen based on a survey that determined which type of consumer goods were most regularly purchased. Each month, Department of Labor researchers assess the value of survey baskets in 32 cities covered by the CPI. Every ten years, the CPI basket is adjusted based on a new survey that reflects changes in consumer behavior and preferences, the introduction of new products and the closure of other products.

Figure 1 shows the relatively steady uptrend of CPI since 2000, with short-term inflation during the 2007-2009 Great Depression and the 2020 Covid-19 Recession. Note that since the last recession, the CPI has risen significantly faster than the average — thus we are currently experiencing 7.5 percent inflation.

Figure 1. Consumer Price Index 2000-2022 for all urban consumers

The Department of Labor needs to make another adjustment called the hedonic adjustment. To some extent, technological advances are captured by adjusting product combinations, adding new products, and removing obsolete ones. Hedonic adjustment predicts the effects of rapid technological advances that can combine falling prices with quality improvements. For example, in 1948, on a mahogany breakfront made for Baker Furniture’s RCA, you could buy the largest combination of RCA Berkshire Festival series radio tuners, phonographs, and television sets. It retails for about $ 4,000 when purchasing a new Cadillac. The TV was a 29-inch diagonal rear projection black-and-white set. This is particularly significant because one of the largest conventional cathode-ray-tube sets ever made was a small 4-inch diagonal.

Today you can buy a much larger HDTV, providing a dramatically high-quality color picture, at a much lower price. Similarly, the first PCs were retailed in 1985 for about $ 20,000, and by today’s standards it was as effective as a doorstep. Not only did the price fall below $ 1,000, but computing power, speed, and storage space increased rapidly. Like TVs, we are now paying much less for much better products. Hedonic adjustment seeks to capture the full impact of these improvements, which is more than just a price reduction suggestion. Although car prices have risen over the years, newer cars are safer, and generally provide better, more sustainable, and better fuel economy, as well as harmonic coordination efforts to capture such quality improvements.

The CPI is currently based on an index of 1982 = 100, so its current value of 280 indicates that consumer prices are, on average, about 2.8 times higher than in 1982. Since 1982, M2 has grown by a factor of more than 10, M1 by a factor of about 50, and the financial base by a factor of over 36,000! With the way the Federal Reserve has handled the money supply, what really calls for an explanation is why prices aren’t already dramatically higher.

The annual percentage change in CPI is the policy of inflation and the most widely used measure. The main option is a GDP price deflator, which includes non-consumer goods, but imports are excluded because they are not part of US GDP. The main difference between CPI and GDP deflator is that CPI is an indicator of representative price of consumer goods, where GDP deflator tries to estimate the growing impact of price changes on any domestically produced product and service, including investment products. Or capital equipment. Imported products are not included in the GDP deflator because they are never part of the US GDP. Some import prices are included in the CPI.

The Department of Labor also collects producer price information because, over time, these ultimately factor into future CPI. The Department of Labor publishes a comprehensive Product Price Index (PPI) for all products, as well as specialized PPIs for different industries and product groups. Looking at the broader PPIs for all products in Figure 2, we can see more pronounced inflation in commodity prices during each recession, as businesses have slowed down and their demand for products has declined. There has also been a significant inflation in 2014-2016, which may be responsible for the increase in oil production.

Figure 2. Producer price index, all products 2000-2021

Since producer prices captured in the PPI are later reflected in the consumer price contained in the CPI, the PPI can be taken as an early warning sign of what might be reserved for the CPI at a probable interval of about six months to one year. If we calculate PPI inflation over the previous 12-month period, we get a PPI inflation rate of 24 percent for all products. The picture is even more grim when we look at some more focused PPIs. For example, the PPI inflation for the metal-producing industries is an incredible and obviously quite alarming 45 percent compared to last year. Soon, some of this will translate into higher consumer prices.

However, a shortcoming of both CPI and PPI is the specific basket of product methods made on these price indicators. The use of a specific basket of products ignores replacement. When the prices of some products go up, our usual response is to replace cheap products to expand our budget. Both the company and the consumer do it. However, many manufacturing companies or construction activities will be limited in the extent to which they can replace alternative materials to steel or aluminum, especially in the short term. No matter how hard the replacement business tries, they need to use some of the products to produce their output. PPI inflation is 24 percent for all products, although it does not necessarily predict future CPI growth so much, it strongly suggests that CPI inflation will continue to rise.