Is the Consumer Price Index (CPI) the Best Measure of Inflation?

The consumer price index (CPI) is a measure of the average change over time in the prices paid by consumers in urban households for a basket of goods and services. These goods and services are broken into eight major groups: food and beverages, housing, apparel, transportation, medical care, recreation, education, and communication.

The CPI is calculated by taking price changes for each item in the predetermined basket of consumer goods and services and then averaging them. Changes in the CPI reflect changes in the cost of living in the U.S. As such, the CPI is an economic indicator that is most frequently used for identifying periods of inflation (or deflation) in the U.S.

But, some economists question whether CPI is the best measure of inflation. For several years, there has been some controversy about whether the CPI overstates or understates inflation, how it is measured, and whether it is an appropriate proxy for inflation. One of the main reasons for this contention is that economists differ on how they believe inflation should be measured. Here we cover CPI (along with some changes made to improve it) as well as some other inflation indices.

Consumer Price Index and Overall Price Changes

Inflation is a rise in the general level of prices and is often expressed as a percentage. It results in a unit of currency effectively buying less than it did in prior time periods. When inflation occurs in the U.S., it indicates a decrease in the purchasing power of the dollar.

The U.S. Bureau of Labor Statistics (BLS) reports the CPI on a monthly basis and has calculated it as far back as 1913. It is based upon the index average for the period from 1982 through 1984 (inclusive) which was set to 100. So a CPI reading of 100 means that inflation is back to the level that it was in 1984 while readings of 175 and 225 would indicate a rise in the inflation level of 75% and 125% respectively. The quoted inflation rate is actually the change in the index from the prior period, whether it is monthly, quarterly or yearly.

Changes in the CPI reflect price changes in the economy. When there is an upward change in the CPI, this means there has been an increase in the average change in prices over time. This eventually leads to adjustments in the cost of living and income (presumably so that income is adjusted to meet a higher cost of living). This process is referred to as indexation.

While it does measure the variation in price for retail goods and other items paid by consumers, the Consumer Price Index does not include things like savings and investments, and can often exclude spending by foreign visitors. 

Consumer Price Index Subcategories

The CPI provides many different subcategories of price indexes. In total, there are indexes for the U.S., the four Census regions, the nine Census divisions, two sizes of city classes, eight cross-classifications of regions and size classes, and for 23 local areas. The U.S. Bureau of Labor Statistics (BLS) publishes CPI data monthly for indexes related to the U.S., the four Census regions, and some local areas.

Indexes are also available for two population groups: the CPI-U and the CPI-W. The CPI-U is for all urban consumers and covers approximately 93% of the total population.

• The CPI-U includes professionals, the self-employed, the poor, the unemployed, and the retired–all residing in urban and metropolitan areas.
• The CPI-W is for all urban wage earners and clerical workers. This accounts for an additional 29% of the population. This measurement skews more towards active workers and those in the lower social classes.

The current CPI measurements do not take into account the spending habits of those living in rural or non-metropolitan areas, including farm families. The current CPI measurements also do not take into account members of the armed forces and those in institutions, such as prisons or mental hospitals.

Economists Differ on How Inflation Should Be Measured

While the CPI is the most widely watched and used measure of the U.S.’s inflation rate, many economists differ on how they believe inflation should be measured. Because the methodology used to calculate the CPI has changed over time–undergoing numerous revisions–there are some critics of the CPI that say that this measurement can be purposefully manipulated by the U.S. government. Other economists argue that the CPI’s viability as an indicator of inflation is questionable simply because it may be a lagging indicator. In other words, it may not be very accurate at capturing current levels of inflation.

Over the years, the methodology used to calculate the CPI has undergone numerous revisions. According to the BLS, the changes removed the supposed biases that caused the CPI to overstate the inflation rate in the past. The newer methodology takes into account changes in the quality of goods and substitution. Substitution, the change in purchases by consumers in response to price changes, changes the relative weighting of the goods in the basket.

The BLS also uses additional indexes to measure inflation. The producer price index (PPI) measures the domestic output of raw goods and services. It attempts to account for the fact that, when producers face input inflation, the increases in their production costs are passed on to the retailers and consumers. Hence, the PPI is a more accurate measure of a country’s economic output because it is not affected by consumer demand.

GDP Deflator

The U.S. Bureau of Economic Analysis (BEA) uses the gross domestic product (GDP) deflator as an additional indicator of the level of inflation in the U.S. The GDP deflator measures the aggregate prices of all goods and services produced by the entire nation; it encompasses both the CPI and PPI statistics.

The CPI, which measures the level of retail prices of goods and services at a specific point in time, is one of the most commonly used inflation measures because it reflects changes to a consumer’s cost of living. However, all calculations based on the CPI are direct, meaning the index is computed using prices of goods and services already included in the index.

The fixed basket used in CPI calculations is static and sometimes misses changes in prices of goods outside of the basket of goods. Since GDP isn’t based on a fixed basket of goods and services, the GDP price deflator has an advantage over the CPI. For instance, changes in consumption patterns or the introduction of new goods and services are automatically reflected in the deflator but not in the CPI.

Gross domestic product (GDP) represents the total output of goods and services. However, as GDP rises and falls, the metric doesn’t factor the impact of inflation or rising prices into its results. The GDP price deflator addresses this by showing the effect of price changes on GDP, first by establishing a base year and, secondly, by comparing current prices to prices in the base year.

Simply put, the GDP price deflator shows how much a change in GDP relies on changes in the price level. It expresses the extent of price level changes, or inflation, within the economy by tracking the prices paid by businesses, the government, and consumers.

What this means is that the GDP price deflator captures any changes in an economy’s consumption or investment patterns. That said, trends observed in the GDP price deflator are usually similar to the trends seen in the CPI.

Personal Consumption Expenditures (PCE)

Personal consumption expenditures (PCEs) is another measure of imputed household expenditures, and how those costs change over time. Released monthly in the BEA, personal consumption expenditures is summarized in the PCE Price Index, which measures price changes in consumer goods and services exchanged in the U.S. economy.

In 2012, the PCE Price Index became the primary inflation index used by the U.S. Federal Reserve when making monetary policy decisions. It is used instead of the Consumer Price Index (CPI) because the PCE Index is composed of a broad range of expenditures that exceeds the limited basket of goods used in CPI. The PCE Price Index is also weighted by data acquired through business surveys, which tend to be more reliable than the consumer surveys used by the CPI. 

Another difference between the PCE Price Index and CPI is that the PCE Price Index uses a formula that allows for changes in consumer behavior and changes that occur in the short term. These adjustments are not made in the CPI formula.

These factors result in an arguably more comprehensive metric for measuring inflation using PCE.