Focus on Economic Data: Consumer Price Index and Inflation, January 16, 2009

INTRODUCTION

Each month, the U.S. Bureau of Labor Statistics (BLS) releases an estimate of the rate of inflation in the United States for the previous month. The report provides the most recent current and seasonally adjusted consumer price indexes for all urban consumers, urban wager earners, and the chained index, plus a breakdown by major expenditure groups. The BLS also collects price level data for major metropolitan areas and regions.

U.S. Bureau of Labor Statistics Announcement, January 16, 2009, Consumer Price Index: December 2008

"The Consumer Price Index for All Urban Consumers (CPI-U) decreased 1.0 percent in December, before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The December level of 210.228 (1982-84=100) was 0.1 percent higher than in December 2007."

TASK

• Review the most recently reported U.S. employment and unemployment data.
• Determine the changes in U.S. employment and unemployment rate from November to December, 2008.
• Determine the factors that have influenced the change in employment and the unemployment rate.
• Explain the implications of the employment and unemployment data for their local economy and the U.S. Economy.

PROCESS

Consumer prices fell for the third straight month in December, led by a record drop in gasoline prices. Inflation for the year 2008 was just 0.1 percent, the lowest in more than fifty years and raising the possibly of deflation, an extended period of falling prices.

The BLS reported that consumer prices dropped 0.7 percent in December, slightly less than anticipated. The 0.7 percent drop in December followed drops of 1.0 percent in October and 1.7 percent in November. The 2008 CPI increase of just 0.1 percent followed an increase in the CPI of 4.1 percent in 2007. The last full year of declining prices on record was 1954.

The core CPI, which excludes food and energy prices, did not change from November to December. For all of 2008, core inflation was 1.8 percent, after an increase of 2.4 percent in 2007. Figure 1 shows the annual rates of inflation from 2001 through 2008. Note that the average inflation rate for all items since 2001 has been 2.4 percent and the core rate has averaged just 2.1 percent. Note also that the inflation rate for all items has fluctuated more widely than the core rate. The different rates of change primarily reflect energy price changes.

Energy prices were the key factor in the overall price level decrease in 2008. In 2008, energy prices, measured as an energy index, fell 21.3 percent, with gasoline prices falling by 43.1 percent. In December alone, gasoline prices fell by a record 17.2 percent. The energy index decreased by 8.3 percent in December as gasoline, heating oil and natural gas prices all decreased.

Figure 2 shows the rates of inflation (deflation) for the twelve months of 2008. Note that the larger the change in the energy index (increase or decrease), the larger the difference between the change in the CPI-U and the change in the core rate. 

Figure 3 is a bar graph of the monthly changes in the CPI from 2002 through 2008. Notice how the monthly changes can vary greatly within a year. Also note that there have been no incidences of three monthly declines in CPI since 2002 until the October-December 2008 period.

What is the Consumer Price Index?

The Consumer Price Indexes (CPI), reported by the Bureau of Labor Statistics, is a monthly measurement of changes in the prices paid by urban consumers for a representative "market basket" of goods and services. An increase in the CPI from one month to another may be evidence of "inflation" in the price level or a reduction in purchasing power.

The CPI measures changes in prices over time. By selecting an appropriate base year and setting the index level for that time period at 100, the CPI compares one months price index level with the base year or any other time period. The current standard reference base period is the average of the period from 1982 to 1084.

The CPI Market Basket

The CPI market basket represents all the consumer goods and services purchased by urban households. Price data are collected for over 180 categories, which BLS has grouped into 8 major groups. These major groups, with examples of categories in each, are as follows:

• Food and beverages (ham, eggs, carbonated drinks, coffee, meals and snacks)
• Housing (rent of primary residence, fuel oil, bedroom furniture)
• Apparel (mens' shirts and sweaters, womens' dresses, jewelry)
• Transportation (new vehicles, gasoline, tires, airline fares)
• Medical care (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
• Recreation (television sets, cable TV, pets and pet products, sports equipment, admissions)
• Education and communication (college tuition, postage, telephone services, computer software and accessories)
• Other goods and services (tobacco and smoking products, haircuts and other personal care services, funeral expenses) 

What Happened to the CPI Market Basket's Prices in December 2008?

The CPI-U for all spending categories decreased by 0.7 percent in December, but the increase was not consistent in all categories. While apparel, transportation, and recreation decreased, food and beverage, housing, and "other" remained the same. The medical care, and education, and communication categories increased. Note: If you look at the employment numbers for December 2008, you will notice that medical care, and education, and communication were the only categories with employment increases. Figure 3 shows the CPI changes for the various spending categories. 

What is Inflation?

Inflation is generally defined as a continual increase in the overall level of prices. It is an increase in average prices that lasts at least a few months. The most widely reported measurement of inflation is the consumer price index (CPI).

The CPI compares the prices of a set of goods and services relative to the prices of those same goods and services in a previous month or year. Changes in the prices of those goods and services approximate changes in the overall level of prices paid by consumers. If the price level of consumer goods and services increases over a period of time, the consumer's purchasing power decreases (assuming, of course, that the consumer's disposable income and spending pattern remain the same).
 
What is Deflation?

Just the opposite of the definition of inflation, deflation is generally defined as a continual decrease in the overall level of prices. It is a decrease in average prices that lasts at least a few months. If the price level of consumer goods and services decreases over a period of time, the consumer's purchasing power increases (assuming, again, that the consumer's disposable income and spending pattern remain the same). 

Measurements of Consumer Prices

There are several measurements or reported levels of the CPI. They are:

• CPI: A measure of the average change in prices over time of goods and services purchased by households.
• CPI-U: The Consumer Price Index for All Urban Consumers. Includes approximately 87 percent of the total population, including wage earners and clerical worker households, groups such as professional, managerial, and technical workers, the self-employed, short-term workers, the unemployed, retirees, and others not in the labor force.
• CPI-W: The Consumer Price Index for Urban Wage Earners and Clerical Workers. Includes households of wage earners and clerical workers, representing approximately 32 percent of the total population.
• C-CPI-U: The Chained Consumer Price Index for All Urban Consumers. This measurement uses a formula that reflects the substitutions consumers make in response to changes in relative prices.
• Core CPI: The average price of the same set of goods and services, without some of the more volatile components, such as food and energy prices.  

How the CPI is Calculated

Assume that there are only three goods (instead of goods and services in over 200 categories in the actual calculation) included in the typical consumer's purchases and, in the base or the original year, the goods had prices of $10, $20, and $30. The typical consumer purchased ten of each good. Total cost of this "market basket" in the base year was $600.

In the current year, the three goods' prices are $11, $24, and $33. Consumers now purchase 12, 8, and 11 of each good. The total current price of this "market basket" is $622, but this would not be an accurate way to compare the "price level." An accurate comparison has to assume a constant pattern of purchasing.

The determination of the CPI for the current year uses the quantities purchased in the market basket in the base year (ten of each good) times their prices in the current year divided by the quantities purchased in the market basket in the base year times their prices in the base year.

Thus [(10 x $11) + (10 x $24) + (10 x $33)] / [( 10 x $10) + (10 x $20) + (10 x $30)] = $680 / $600 = 1.133. That is, prices in the current year are 1.133 times the prices in the original year. Prices have increased on average by 13.3 percent. The quantities are the base year quantities in both the numerator and the denominator.

By convention, the indexes are multiplied by 100 and reported as 113.3 instead of 1.133.

The base year index simply divides the prices in the base year (times the quantities in the base year) by the prices in base year (times the quantities in the base year). The base-year index then is 1.00; or multiplied by 100 equals 100.

How the CPI Data are Collected

The Bureau of Labor Statistics samples the purchases of households representing 87 percent of the population. The consumer price index measures prices of goods and services in a market basket of goods and services that is intended to be representative of a typical consumer's purchases. Forty-one percent of the market basket is made up of goods that consumers purchase. The other fifty-nine percent includes services.

Goods and services sampled include food, clothing, housing, gasoline, other transportation prices, medical, dental, and legal services, and hundreds of other retail goods and services. Taxes associated with the purchases are included. Each item is weighted in the average according to its share of the spending of the households included in the sample. Almost 80,000 prices in 87 urban areas across the country are sampled by Bureau of Labor Statistics professionals. Visits and phone calls are made to thousands of households and thousands of retail stores and offices.

Causes of Inflation

Over short periods of time, inflation can be caused by increases in costs or increases in spending. Inflation resulting from an increase in aggregate demand or total spending is called demand-pull inflation. Increases in demand, particularly if production in the economy is near the full-employment level of real GDP, pull up prices. It is not just rising spending. If spending is increasing more rapidly than the capacity to produce, there will be upward pressure on prices.

Inflation can also be caused by increases in costs of major inputs used throughout the economy. This type of inflation is often described as cost-push inflation. Increases in costs push prices up. The most common recent examples are inflationary periods caused largely by increases in the price of oil. Or if employers and employees begin to expect inflation, costs and prices will begin to rise as a result.

Over longer periods of time, that is, over periods of many months or years, inflation is caused by growth in the supply of money that is above and beyond the growth in the demand for money.

Inflation, in the short run and when caused by changes in demand, has an inverse relationship with unemployment. If spending is rising faster than capacity to produce, unemployment is likely to be falling and demand-pull inflation increasing. If spending is rising more slowly than capacity to produce, unemployment will be rising and there will be little demand-pull inflation.

That relationship disappears when inflation is primarily caused by increases in costs. Unemployment and inflation can then rise simultaneously. 

The Costs of Inflation

Understanding the costs of inflation is not an easy task. There are a variety of myths about inflation. There are debates among economists about some of the more serious problems caused by inflation.

High rates of inflation mean that people and business have to take steps to protect their financial assets from inflation. The resources and time used to do so could be used to produce goods and services of value. Those goods and services given up are a true cost of inflation.

High rates of inflation discourage businesses' planning and investment as inflation increases the difficulty of forecasting of prices and costs. As prices rise, people need more dollars to carry out their transactions. When more money is demanded, interest rates increase. Higher interest rates can cause investment spending to fall, as the cost of investing increases. The unpredictability associated with fluctuating interest rates makes customers less likely to sign long-term contracts as well.

The adage "inflation hurts lenders and helps borrowers" really only applies if inflation is not expected. For example, interest rates normally increase in response to anticipated inflation. As a result, the lenders receive higher interest payments, part of which is compensation for the decrease in the value of the money lent. Borrowers have to pay higher interest rates and lose any advantage they may have from repaying loans with money that is not worth as much as it was prior to the inflation.

Inflation reduces the purchasing power of money. If your income is fixed or does not increase as much as the rate of inflation, you cannot purchase as many goods and services this year as you could last year. Your real income decreases.

On average, individuals' incomes do increase as inflation increases. However, some peoples' wages go up faster than inflation. Other wages are slower to adjust. People on fixed incomes such as pensions or whose salaries are slow to adjust are negatively affected by unexpected inflation.

Inflation redistributes income. Those who owe money (borrowers) can repay it with inflated dollars (if their income increased to keep up with the inflation). Those who are owed money (lenders) receive dollars with less value when loans are repaid. Hopefully, the principal and interest received have at least the same purchasing power as the money loaned. In this situation, income is redistributed from lenders to borrowers.

CONCLUSION

Consumer prices fell for the third straight month in December, led by a record monthly drop in gasoline prices. Inflation for the year 2008 was just 0.1 percent, the lowest in more than fifty years and raising the possibly of inflation, an extended period of falling prices.

The consumer price index (CPI) is a generally accepted measurement of consumer prices and changes in the purchasing power of consumer income. Many automatic contracts, price, and income raises are tied to the change in the CPI. Most notably, Social Security payment increases are tied to the annual change in the CPI.

Critics of the CPI say that it is inaccurate in that it does not take into account that consumers will seek substitutes when prices rise, and that the "average" consumption pattern (lifestyle) of consumers changes over time. New and improved products are continuously entering the marketplace.

If you are interested in how the BLS measures the price changes of different consumer products, go to the BLS web page, "Consumer Price Index Fact Sheets ."

ASSESSMENT ACTIVITY

1. What is the different between demand-pull and cost-push inflation?
    
2. Which measurement, the CPI-U or the core rate is the most meaningful measurement of inflation?
    
3. Explain how a borrower can actually benefit from inflation?

EXTENSION ACTIVITY

An article in the August 2008 "Monthly Labor Review ," addresses "Common Misconceptions about the Consumer Price Index: Questions and Answers." The BLS web page has a summary of the article . Read the summary and discuss whether or not you think the CPI is a meaningful measurement of "cost of living."