What Is the Consumer Price Index?

The Consumer Price Index (CPI) is one of the nation’s most closely watched economic metrics. Released monthly, it measures the year-over-year change in the cost of a basket of consumer goods, including clothing, food and furniture. It is so popular because it can signal both inflation and deflation. This is how the CPI can affect your finances over the long term.

If you’re worried about preparing your finances for any potential movements in the economy, consider talking to a financial advisor.

Inflation and the Consumer Price Index

Our economy experiences inflation when prices consistently rise and the dollar’s value declines. Your purchasing power drops, so your money won’t buy you as much as it did before.

The Consumer Price Index (CPI) is important because it is one measure the federal government uses to track the rate of inflation. It examines how the average costs of certain items fluctuate over a specific period. While the report is available monthly, you can also search for a yearly CPI. It also provides separate indices for 23 metropolitan regions to determine where inflation spiked the most.

You won’t find details in the CPI about shifts in prices for every single good or service known to man. Instead, it uses a market basket, which is a set list of items from certain sectors that represent the greater economy. It measures how much households spend on over 200 different types of items.

This includes several everyday items.

Food
Clothing
Housing
Transportation
Education
Recreational activities
Medical treatment and fees for parking
Water
Other government services

The CPI can be very specific and even includes any taxes you pay when you shop or pay for a service. However, the CPI doesn’t consider the price changes of different investment types, such as bonds, real estate, life insurance and stocks.

Instead, the index tracks the spending habits of all residents and workers living in a metropolitan area, including low-income and unemployed individuals. Therefore, the CPI covers over 90 percent of the country’s population, excluding those in rural areas, the military and prison.

You can find different versions of the index, too.

Chained Consumer Price Index. The Chained Consumer Price Index adjusts for the chance that people will choose to buy lower quality, less expensive products when there is inflation.
Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The Consumer Price Index for Urban Wage Earners and Clerical Workers only factors household data for those whose income mostly derives from hourly wages.

Calculating the Consumer Price Index

Newspaper clippings reading "cost of living."

To gather data for the CPI, the Bureau assigns employees to collect the prices of tens of thousands of products and services every month. It also surveys about 30,000 households annually to ascertain how much they’re spending on products for their families. All of the items in the CPI’s market basket are assigned a weight based on the percentage of spending that they make up.

After determining which items go into the fixed basket and their respective prices, you can find the CPI by multiplying a product’s current price by the number of those items in the basket. You repeat this for all of the other items in the basket. You can then add all these products together to find the price of your market basket in one year.

Finally, complete the CPI formula by dividing the cost of a market basket in one year by the cost of the basket in a comparison year. Multiply the quotient by 100.

Why the Consumer Price Index Matters

In addition to helping identify inflation, the CPI is an indicator of how the economy is doing and whether there is deflation, which is when overall prices decrease. Therefore, government members can reference the CPI when making economic policy decisions.

The CPI also often serves as a measure of the cost-of-living. It helps determine how much money you’ll receive in benefits from programs like Social Security, food stamps and veterans’ assistance programs.

In some ways, however, the CPI could be more useful. It doesn’t reflect changes in the quality of items over time and doesn’t say much about the spending patterns of the poor or those living outside of urban areas.

The CPI does not explain how income taxes may affect prices. Adding new items to the market basket isn’t ideal because the basket should remain fixed in order to compare prices across multiple years. Plus, if you’re trying to figure out how much house you can afford, keep in mind that the CPI includes rental costs to show the monthly price of having your own home.

The CPI is often referred to as headline inflation because it doesn’t remove any items from the index that could skew its data. Core inflation, on the other hand, ignores food and energy because they often have sudden price shifts. Because of this, some see core inflation as a more accurate measurement of price fluctuations.

Bottom Line

By revealing how prices fluctuate from year to year, the Consumer Price Index can help policymakers and economists identify inflation and decide on economic policy tweaks. It’s not a perfect tool, however, which is why there are other ways to measure inflation, such as core inflation. Naturally, beating inflation is a key concern when it comes to investing. It’s a major reason why investors who aren’t afraid of a little risk choose stocks over bonds.

Tips for Managing Finances

Working with a financial advisor can be one of the best ways to financially prepare for the ebbs and flows of the market and economy as a whole. Finding a financial advisor to work with doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Wondering how the economy has been impacted by inflation or how it could be? Check out our free inflation calculator.