Amid the worst inflation spike in four decades, with CPI up 8.6% year-over-year, it’s no surprise that there’s renewed interest– and more scrutiny– on how official numbers are calculated. The U.S. The Bureau of Labor Statistics (BLS) uses the Consumer Price Index or the CPI to derive its inflation rates, which usually goes on to become a headline grabbing figure with far reaching effects on economic policy (i.e interest rate hikes) and overall market performance.
Though the model has withstood the test of time, first coming into use in 1917, it wasn’t without some revisions and controversies along the way, many of which are being revisited now. Critics have long pointed out CPI has limited applicability in real life situations, especially given the complicated consumer culture we live in today, while advocates have stood by it for its straightforwardness and practicality.
Though the government still relies on CPI, in recent years it’s also broadened its arsenal to gauge overall economic health, producing metrics like the PCE – now the Federal Reserve’s preferred method – and core inflation to address some of CPI’s shortcomings.
Erica Groshen, a former commissioner of the Bureau of Labor Statistics once called the CPI a “headline measure of inflation in the U.S. economy.” While it really does lead the news and gets quoted more than other metrics, CPI isn’t the only way inflation is measured nor does it come in one version. In fact, the BLS itself publishes two indexes each month: the CPI-U and CPI-W.
The CPI that’s widely reported and matters the most to financial markets is the CPI-U or the Consumer Price Index for All Urban Consumers . It represents the 93% of the U.S. population not living in remote rural areas but doesn’t cover spending by people living in farm households, institutions, or on military bases. The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) covers the 29% of the U.S. population living in households with income derived predominantly from clerical employment or jobs with an hourly wage.
The aim of CPI is to measure the cost of living in a given year for one US household by comparing it to a base year. Its exact definition then, is the average change in the prices paid by urban consumers for a market basket of consumer goods and services over a given period of time.
BLS also calculates the CPI-U or CPI as a weighted average of a basket of goods and services, which acts as a representative sample for U.S. consumer spending. The basket is made up of about 80,000 prices from retail and service establishments, which are broken into eight major groups: food and beverages, housing, apparel, transportation, medical care, recreation, education, and communication. The assigned weights to each product reflect the relative importance of the goods and services in the total consumption of households.
To get a CPI figure, the cost of the market basket (the weighted sum of all the goods and services) in a given year is divided by the cost of the market basket in the base year, or a year of reference. The result is then multiplied by 100.
The 8.6% inflation rate in the May 2022 monthly report for example, is the percent change in CPI year-over-year from May of 2021 to May of 2022.
Much of the criticism surrounding CPI in the past has been about how it overstates inflation. In 1995, Congress commissioned a group of academic economists led by Michael Boskin to investigate whether this was true. The study the economists put together, now referred to as the Boskin Report, concluded that CPI did overestimate inflation and gave three main reasons to support the authors’ claims: the model omitted consumer substitution, it didn’t fully account for quality change, and it failed to properly reflect the addition of new goods.
BLS introduced some changes since then, mainly to offset substitution and quality of good bias. It reframed the CPI as a way to gauge cost of living versus cost of goods – a subtle difference that focused more on how much it costs for a person to feel that her consumption provides an equal level of satisfaction or utility.
Not all were on board with the methodology to achieve this, which included much more complicated calculations than adding up the price of all the goods. The change was also thought of a way for the U.S. government to report a lower CPI, which has gained more traction among people who believe inflation numbers are now understated.
BLS still produces CPI numbers monthly and many economists believe in its accuracy. The monthly report also includes other inflation gauges such as the Producer Price Index (PPI) which focuses on the production process, the Employment Cost Index (ECI) that looks at the labor market, and the International Price Program (IPP) for imports and exports.
Other forms of inflation metrics have also grown in prominence over the years. The Fed’s preferred barometer for inflation is the Personal Consumption Expenditure (PCE) produced by the Bureau of Economic Analysis (BEA) which uses the same price data that BLS collects for CPI. Unlike CPI however, which only measures items paid for out-of-pocket by consumers, PCE measures the change in prices for all consumption items. PCE is useful because it adjusts for substitutions and provides a more comprehensive coverage of goods and services, though for some economists, that makes it too broad. Also unlike CPI, it uses information entities such as nonprofits, governments, and corporations.
Both PCE and CPI can also be calculated excluding products from energy or food, which tend to be the most volatile to get a “core” value for inflation. Core inflation is the main focus for central banks like the Fed when setting monetary policy, with the logic being that the volatility from those sectors are the extra “noise” in headline inflation rates, which might be temporary and so wouldn’t warrant permanent changes.
The far reaching effects of the inflation rate– on policy and markets alike – have been especially pronounced this year. On June 10 for example, the S&P 500, Dow Jones Industrial Average, and the Nasdaq tumbled on reports of inflation hitting a forty year high, while the Fed responded by hiking up interest rates three times this year alone.
Adding private market exposure to a portfolio – especially asset classes such as real estate or art – can offer a potential hedge against inflationary pressures facing our economy today.
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