The consumer price index is essentially a snapshot of where consumer spending is today versus a historic point, and a good look at inflation and deflation. It tracks what the average person — in theory — pays for everything from transportation and apparel through to medical care and dinner on the town and everything in between.
These prices that are tracked over time are then used as data points that influence all kinds of mechanisms in the economy and even the social safety net, by everyone from city government officials and bankers to the U.S. Fed. Understanding how to use the consumer price index is great for business planning — but it’s also an inherently flawed data set.
TL;DR (Too Long; Didn't Read)
The consumer price index tracks what a fixed list of goods costs over months and years; this gives governments, institutions and citizens the data through which inflation and deflation are tracked.
Who Is Included in the CPI?
Before learning about how the consumer price index helps to shape the economy and provide consumer insights, it’s important to understand that the CPI doesn’t cover everyone. It makes sense that the CPI does not cover consumer pricing for people in mental hospitals or prisons, and even active armed forces members, but it’s surprising that it also doesn’t cover people living in non-metro, rural and farm areas. So, essentially, the CPI reflects life in the big city, not life in small-town U.S.A. As flawed as this may sound, it still averages out to about 87% of the population.
It also doesn’t have a broad-stroke approach to the economy, because it has a fixed “basket of goods” that is supposed to represent the average purchasing needs for the average person. But those purchases don’t necessarily translate across cultural or generational lines, and they may vary state to state, even city to city. These products that are tracked price-wise to form the CPI, in fact, come from the shopping habits of just 7,000 families in America (well, 7,000 times two: the quarterly spending habits of 7,000, but the biweekly purchasing trends of another 7,000).
This snapshot provided by the CPI is fallible for many reasons, most of all because of its inability to be as fluid as the average shopper tends to be. Consider any time you’ve gone shopping — is what you buy written in stone, or do your shopping habits fluctuate based on what’s available on shelves and the merchant pricing practices? Of course your purchases fluctuate, because you like sales and because market supply/demand is an unpredictable beast. The CPI can’t possibly encapsulate this because it’s a fixed basket of goods, and it’s an average of a larger group of consumers.
So Why Use the CPI?
Because numbers have to come from somewhere, because governments need to know what things cost for people, because industry needs to know what kind of financial realities exist in the day-to-day.
There can be no perfect way of tracking consumer spending, because people vary wildly in what they need, like, love, use and want. For instance, you may consider peanut butter on toast and black coffee as indispensable components in your daily routine, whereas it’s cereal, orange juice and a glass of milk for your neighbor down the hall. So while tracking is imperfect, it’s a critical tool for understanding some staple costs for people.
By tracking a group of fixed items over time, analysts, businesses, investors, legislators and anyone else interested in the economy get a glimpse of inflation and the cost of living. That cost of living has a vast influence — there are unions whose collective bargaining agreements are tied to the CPI, for instance, so when costs escalate, so too do their wages (and vice versa). Social Security, the cost of school lunches, distribution of food stamps, retiree benefits and so much else are all important uses of the consumer price index data.
What’s the “Basket of Goods”?
Ever since the early days of the CPI, there have been a group of “goods” used to deduce what’s going on with the cost of living for the average person. As mentioned, 7,000 people provide information on a quarterly basis as to their core spending habits. These are tracked for the CPI, but there are another 7,000 who track purchasing choices they make during two-week periods. These latter respondents are those who inform what products get included in the future “basket of goods” that includes approximately 80,000 tracked items across roughly 200 categories of goods and services.
There are eight primary categories for things tracked. In them are things like:
- Transportation: Cost of airline fares, gas and oil prices, vehicle insurance, cost of buying a new vehicle.
- Apparel: Prices for common clothing, like men’s shirts, women’s dresses, kid’s shoes.
- Medical Services: From common pharmaceutical prescriptions and medical supplies to general physician services, and things like eyeglasses and hospital visits.
- Food & Beverages: Staples like coffee and morning cereal, chicken legs and wine, dining out, convenience snacks and milk, these are all tracked under food and beverages, and it’s arguably the category that is most likely to suffer substitution bias.
- Recreation: From buying bikes to catching an NBA game, to buying TVs, pet products and other sports equipment: all of these factor into recreation.
- Education and Communication: This category covers postage fees, telephone packages, computer software and subscriptions, tuition for college and other educational programs, and accessories in any of these areas.
- Housing: In a perfect world, rent is one-third of a consumer’s income, so this is an important category focusing on the rent paid by consumers, plus things like housing insurance, home energy costs like fuel or oil, the price of furniture and so on. But the CPI doesn’t pay attention to investments — which can include real estate, so only the consumer’s primary residential costs are included for CPI purposes.
- Other Goods and Services: Things like the cost of tobacco or getting dry cleaning or a haircut, maybe the funeral expenses for burying a loved one, and so many other little things that factor into monthly costs for the average person.
The Consumer Price Index Formula
The simplest explanation of figuring out the CPI is that it’s the cost of the market basket in the given year divided by the cost of market goods in the base year multiplied by 100, then subtracting 100. Sounds more complicated than it is. The base year is used for quite a while, and in 2019, the Bureau of Labor Statistics was still using 2010. Here’s a hypothetical “market basket” to help illustrate how the consumer price index gets calculated.
It's late 2019, you've been shopping and you spent $55, which breaks down as:
- $10 on eggs
- $10 on milk
- $20 on chicken
- $15 on breads and cereal
But in 2010, say you would have spent $40 to buy the same goods, as follows:
- $7 on eggs
- $8 on milk
- $15 on chicken
- $10 on breast and cereal
So, 2019's $55 gets divided by 2010's $40, equaling 1.375. This is multiplied by the CPI base of 100, for a total of 137.5. Now 100 is subtracted, leaving the CPI remaining, 37.5% – meaning the hypothetical costs of these consumer goods have risen 37.5% from the base year of 2010 through to 2019. (Keep in mind, these figures are just examples.)
For one item, say it’s a T-bone steak you’re interested in the CPI for, and today’s steak costs you $45 at a nice restaurant. In 2010, perhaps you might have paid $30 in a post-recession America, but the prices have gone up considerably as the economy has improved. So, $45 divided by $30 is 1.5, times 100 gets you 150. Subtract 100 off that and you find the CPI on that tasty steak is an inflation of 50% since 2010.
The Flaw of Substitution Bias
But take any kind of averaging like this and you run into problems, because life comes with all kinds of dynamic opportunities that make consumers improvise or change things up when market realities make prices or availability prohibitive.
Consider the price of bacon — say it shoots up over 25% in costs over a year, all tied into incidents of swine flu and other epidemics that create a global shortage. What’s a breakfast-lover to do, pony up all that extra money for bacon, or do they spend differently? Behavioral economics indicate the consumer will consider other options if it means stretching their dollar further. And look, there’s a lovely turkey-apple sausage on sale at a far lower cost, and suddenly there’s a little extra money in the shopping budget and ice cream is now added to the menu.
And that’s the problem with the CPI: as much as it may try tracking the other 7,000 families who’re documenting all their purchases over two-week periods, CPI doesn’t account for how door-crasher sales may influence spending habits, or food safety recalls or seasonal fluctuations. But the substitution bias is a huge one, since even within the same category results, the price of bacon itself varies tremendously — you can buy bacon of sketchy origins with mass farming practices for bargain-basement prices, or you can pay as much as five to 10 times more for bacon from ethically-raised free-range animals.
Static Basket vs. Dynamic Economy
That fixed basket of goods problem rears its head again in the evolution of world markets and the ever-shifting availability of goods. For instance, today’s consumer subscribes to a number of services or products that a 2010 consumer may not have even considered — like Spotify or Netflix — but a 2010 base price doesn't exist for entertainment subscriptions, since it was still a DVD- and CD-buying public at the time. Of course, that's a hypothetical scenario, but it illustrates the problem with an ever-changing market.
As years pass, the lists evolve, but these problems remain true — technologies, foods and services deemed to be “fixed” items can be obsolete, underreported or just flat-out wrong. Say you’re tracking someone today who no longer ever buys DVDs. Well, their cost of living hasn’t gone down — it’s just evolved to a different kind of spending, because now they’re paying for Hulu, Amazon, Netflix and Disney+, at $40 or more a month, and maybe also Spotify and other audio or video subscriptions.
Today’s economy is changing and evolving at a clip unlike any in history. From internet to digital services to the gig economy, there are all sorts of new ways to spend money that are not necessarily reflected in the consumer price index — or which are just taking a long time to get normalized in these indexes.
Small Biz Uses of CPI
As a small business owner, the CPI is and isn’t useful. It’s useful in that it gives you a sense of what the rate of inflation is and what the average costs are for consumers. This can help you understand why your costs are going up (or down) as well.
Perhaps you’re facing the reality that your costs are increasing and they either need to be absorbed or passed on. But consumers paying more everywhere else ultimately need to choose whose products they’re not willing to pay more for. Will yours be among the items they put on the “live without” column in an economy where cash is tight and costs are high?
Perspective is helpful. But then again, the CPI and all that trivia is great to know, but sometimes the costs are what they are, and someone’s got to pay. If your prices need to increase, sometimes all the data in the world can’t offset the needs there in the black, red and white of a balance ledger.
- Inflation Data: Why Inflation Matters to Small Businesses
- Bureau of Labor Statistics: Consumer Price Index October 2019
- Investopedia: Consumer Price Index
- Quicknomics: Calculating the Consumer Price Index
- Investopedia: Why the CPI is Controversial
- Bureau of Labor Statistics: CPI Frequently Asked Questions
- Investopediaa: What is a Market Basket?