What Is the Consumer Price Index and Why Is It Important?

What Is the Consumer Price Index and Why Is It Important?

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What is the Consumer Price Index?

The Consumer Price Index (CPI), according to the U.S. Bureau of Labor Statistics (BLS)1, measures the average price changes over time paid by all urban consumers for a market basket of consumer goods and services. The primary function of the CPI is to act as a measure of inflation - or the increase in cost over a given period of time to maintain the same standard of living expressed as a percentage change in the CPI over a given period, usually a month or year.

Monthly CPI data is published by the BLS detailing the increase in the overall price level over the previous month. Generally speaking, when people use the term CPI, they refer to the Consumer Price Index For All Urban Consumers (CPI-U). However, the BLS also publishes the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), which employs a different methodology. The CPI-W details the inflation rate for all urban wage earners and clerical workers based on their consumption expenditure surveys, whereas the CPI-U is based on all urban consumers.

How Is the CPI Calculated?

The CPI calculation is a weighted average of the price change in a basket of consumer goods and services that a typical United States household consumes. Each item is weighted to be accurate to the amount of a given good the average U.S. consumer will likely use. This gives us a broad view of the U.S. economy's overall price level and cost of living - otherwise known as price inflation. Examples of consumer goods that go into the CPI are medical care, transportation, food, power, water, shelter, etc. Price data on all these products and services are weighted and aggregated by the BLS, coming to the final number that represents the CPI. Below is a table containing the weights and weight changes made to the U.S. CPI over a recent period of time, as well as the underlying CPI index from July 2022 to May 2023.

Why is the Consumer Price Index Important?

The CPI is what we use to calculate the ‘’inflation rate’’, expressed as a percentage change between months or over a year—indicating the cost of living for the average resident in the U.S. economy and serving as a basic barometer for its health. It’s also used by important government bodies like the Federal Reserve (the U.S. central bank, sometimes shortened to ‘’the Fed’’) to make monetary policy decisions, which have a significant impact on the overall economy as well as the exchange rate of the U.S. dollar.

The CPI also allows us to correct other figures to remove inflation as a factor, which we call ‘’real’’ figures. For example, if a country has a GDP of $100 billion in one year and $102 billion the next, then the nominal dollar value GDP has increased by 2%; however, if inflation is at 2%, then we adjust this figure and the real GDP growth is 0% (or real GDP is $100 billion), as the economy has not become more productive, the prices of its goods have simply increased.

The Consumer Price Index is also used as an essential benchmark for investors as a ‘’break even’’ benchmark. This is because if your investments are less than the CPI, they have not beaten the rate of inflation and the purchasing power of your portfolio value is the same as in the previous month or year.

The Consumer Price Index also serves as a de-facto cost-of-living index as it is the primary tool to make cost-of-living adjustments that are applied to social security payments, federal pensions and income tax brackets in the United States.

How Does the CPI Affect Forex?

The CPI affects Forex in a few select ways. It indicates the overall health of the US economy and gives insight into what decisions a central bank may choose to make.

Generally speaking, countries want their inflation to be low and stable, as this makes it easy for businesses and individuals - both foreign and domestic to make investments, and gives them the confidence to do so, which can increase the value of that country’s currency through spurring its economy. This means that CPI is an important thing to watch out for as inflation getting too high could be a negative indicator for the economy as a whole.

The Federal Reserve uses CPI data to make economic policy decisions directly affecting the currency and overall economy. Generally speaking, the interest rate of a central bank and the CPI/inflation are inversely related. When a central bank increases interest rates, this is likely to decrease inflation and vice versa. However, these institutions must also consider how it affects unemployment, which is a difficult balance to strike. For example, if the Fed decides that inflation is too high, it might conduct what is referred to as a ‘’hawkish rate hike’’, meaning that it would increase the interest rates in hopes that it will lower the CPI and quell the effects of inflation. This might increase the value of the U.S. dollar, as it is now a more favourable currency to hold, giving a higher return via interest. However, it may also weaken their economy, as it is now more expensive to borrow money and invest in growth, weakening the currency in the long term. Conversely, if the rate of inflation is low, the Federal Reserve may choose a 'dovish’ rate cut to avoid deflation and its effects, as well as spur investment due to a cheaper borrowing rate.

Limitations of the Consumer Price Index

While the Consumer Price Index can be a useful tool, both for traders, economists and governments, it does have some limitations as an economic measure.

The CPI is limited in that it is based on U.S. consumer spending - however, this doesn’t represent all items produced in an economy. So, as a barometer for overall economic activity, it is flawed. Metrics like GDP (Gross Domestic Product) would be much more relevant for this.

The CPI has been criticized for its inability to account for consumers’ choice to substitute some goods or services for others. For example, in a given month, the price of apples may rise significantly. It may be that most consumers decide to substitute that good with oranges, a similar fruit that may have stayed the same in price. However, the CPI now adjusts the weightings of different consumer goods and services based on a consumer expenditure survey.

Another limitation of the CPI is that it does not account for increases in the quality or value-added of certain products, particularly technology. For example, suppose a new vehicle is included in the CPI. In that case, the CPI does not account for the fact that a car built in 2023 will likely have better performance and technology than a comparable car built in 2013, making it a superior good. This makes them unfair to compare on the same scale and may mean that the CPI overstates inflation, as increases in quality are not accounted for.

A further criticism of the Consumer Price Index is that it is too heavily affected by volatile commodities such as energy and food products. In some instances, the CPI may rise or fall in ways less indicative of overall price levels and more of commodities volatility. For this reason, some choose to use what is known as the Core CPI, which excludes these two commodities in their calculation or even the ‘’Core Core CPI’’, which also excludes real estate, used cars and trucks.

The Bottom Line

The CPI is the primary economic indicator of inflation used by the federal government, economists, and traders alike. While not a perfect measure, it allows us to gauge inflation in a given economy which can give us insight into the purchasing power of a currency, indicates governmental decisions and enables us to correct metrics such as GDP or adjust payments to account for cost-of-living.

  1. https://www.bls.gov/cpi/questions-and-answers.htm#:~:text=Another%20limitation%20is%20that%20the,area%20with%20a%20lower%20index.
  2. https://www.ons.gov.uk/economy/inflationandpriceindices/articles/consumerpriceinflationupdatingweights/2023
  3. https://tradingeconomics.com/united-states/consumer-price-index-cpi
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