Consumer Price Index (CPI): Does It Measure Inflation?

What is Inflation?

Before we discuss the CPI and government economic data, we much first fully understand the concept of inflation. Inflation, in the most general terms, is a RISE in price levels of goods and services measured over a period of time. When price levels rise, each unit of currency buys fewer goods and services. Inflation also measures the erosion in purchasing power of money, the loss of REAL value in the medium of exchange. Inflation impacts everyone in society, rich or poor, young or old, working or unemployed. Anyone that has to buy food, goods, and services, pay bills, or transact in the economy is directly affected by inflation.

The CPI – official measure of inflation.

The government’s key measurement for inflation is known as the CPI (Consumer Price Index). It has been around since 1913 and traditionally measured a basket of goods, which consumers would purchase. Then the price the basket of goods was compared on a year-over-year basis.

For instance you price a steak, a loaf of bread, a gallon of milk, etc. The following year you price the same products, look at the price change, and you are able to determine the rate of inflation. How much have items increased in price. That is (was) the purpose of the CPI, the rate of change on a fixed basket of goods (with a modicum of replacements when a product is no longer serving its core use, such a computer for a typewriter).

The CPI is very important data point for a couple of key reasons:

  1. Used to adjust Social Security benefits.
  2. The Federal Reserve uses it as their key measure of inflation to adjust monetary policy.

Obviously a lower CPI would be beneficial for both those key reasons.

The Cost of Living?

When the CPI came about it was used to strictly measure INFLATION, as described above. It did so for 70 years without any major changes. More recently in the last few decades, the model used for calculating the CPI has changed drastically. In fact, it no longer measures inflation, but rather the “cost of living”.

The Cost of Living measures the CHOICES a consumer has made based on price changes. In fact INFLATION directly impacts those choices. Many of the changes that have been made to the CPI over recent years have been argued based on the Cost of Living and the freedom of choice. It would seem a sound argument if we forget the purpose of the CPI to measure inflation.

The “Cost of Living” is not synonymous with inflation, yet politicians and the media frequently use the words “inflation” and “cost of living” interchangeably.

The philosophy behind the changes.

The first big change was made in the mid 1980s, it removed housing from the CPI and replaced it with a “rental equivalent”. It was argued that not everyone buys a house and some that do buy also rent homes, thus we should measure the inflation of rent rather than the inflation of …