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.

This "Focus on Economic Data" lesson focuses on the U.S. Bureau of Labor Statistics announcement dated September 16, 2009 on the "Consumer Price Index: August 2009." 

TASK

  • Identify the current rate and recent changes in the consumer price index.
  • Identify the factors that have influenced recent changes in the rate of inflation.
  • Identify the potential policy implications of the current economic conditions, including deflation.
  • Describe how inflation and deflation impact individuals, families, and different groups in the economy.

PROCESS

U.S. Bureau of Labor Statistics Announcement, September 16, 2009, Consumer Price Index: August 2009

"On a seasonally adjusted basis, the Consumer Price Index for all Urban Consumers (CPI-U) rose 0.4 percent in August, the Bureau of Labor Statistics reported today. The index has decreased 1.5 percent over the last 12 months on a not seasonally adjusted basis."

A look at the recent monthly changes in the CPI-U shows a rather erratic pattern of increases and decreases.  Late 2008 saw several months of decreases. Early 2009 saw monthly increases of between 0 and .7 percent.  It is difficult to generalize a trend from month-to-month changes. The CPI-U increased 0.4 percent in August.  On an annualized basis, assuming similar monthly increases continue, this would mean a 4.8 percent rate of inflation over a year. But wait! The second sentence of the announcement explains why this extrapolation to an annual rate may not be accurate.
 
"The 0.4 percent seasonally adjusted increase in the CPI-U was driven by a 9.1 percent rise in the gasoline index. This increase accounted for almost the entire advance in the energy index and over 80 percent of the overall increase. Despite the August increase, the gasoline index has fallen 30.0 percent over the last 12 months."

Energy prices are historically much more volatile than the prices of most other goods and services. The energy price index (primarily gasoline) in August followed a year of irregular monthly increases and decreases. For this reason, many economists and planners look the "core CPI," a measurement that excludes energy and food, as a more meaningful measure of inflation.

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 over time 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 month's 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 1984.

To see how the CPI works, you can go to the BLS CPI Calculator. The CPI Inflation Calculator allows you to calculate the value of current dollars in an earlier period, or to calculate the current value of dollar amounts from years ago. Consumer Price Indexes often are used to escalate or adjust payments for rents, wages, alimony, child support and other obligations that may be affected by changes in the cost of living.

Real vs. Nominal Measurements

In many cases, data should be adjusted for a change in the price level to make comparisons over time more meaningful.  The term "nominal" is used to refer to a measurement in current dollars. To adjust for inflation and determine a "real" value, the nominal value is adjusted by the price level change. A measurement such as gross domestic product in nominal terms refers to the measurement at current dollars (prices.) To compare GDP in two years, the rate of inflation between the years must be subtracted to determine the real change. 

The same is true for income and purchasing power. Suppose Mr. Jones made $50,000 in 2008 and $52,000 in 2009. His income increased by $2,000 or 4 percent from 2008 to 2009. If the rate of inflation between 2008 and 2009 was 5 percent, Mr. Jones' purchasing power actually decreased by 1 percent. His 4 percent increase in income did not purchase the same amount of goods and services as it did in the previous year. Inflation reduced his purchasing power.

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 (men’s shirts and sweaters, women’s 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 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).

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.

What Happened to the CPI Market Basket's Prices in August 2009?

Figure 1 shows the increases or decreases in the price level of several components of the CPU-U. Note that while energy prices increased significantly, other categories of spending increased very little or decreased. How price changes in August impacted you are a result of your personal spending patterns. The CPI is an assessment of the impact of price changes on an "average" urban consumer with an "average" spending pattern. If you spend a large portion of your income on energy, you were impacted more in August than someone who does not spend as much on energy.

 

Percent Changes in CPI
All Urban Consumers U.S. City Average
August 2009
  August 2009 12 months Aug. - Aug.
All Items .4 -1.5
   Food .1 .4
   Food at home .0 -1.6
   Food away from home .1 3.0
   Energy 4.6

-23.0

   Energy commodities 8.5 -30.8
   Gasoline 9.1 -30.0
   Fuel oil 6.2 -39.9
   Energy services .0 -10.6
   Electricity -0.1 -1.2
All items less food and energy .1 1.4
   New vehicles -1.3 .5
   Used cars and trucks 1.9 -5.4
   Apparel -.1 .6
   Medical care commodities .5 3.7
   Shelter .1 .9
   Transportation services .6 1.4
   Medical care services .2 3.2

 

Highlights (summarized from the September 16 BLS announcement):

Energy: The energy index rose 4.6 percent in August after falling 0.4 percent in July. The energy commodities index rose 8.5 percent as the gasoline index rose 9.1 percent in August following a 0.8 percent decline in July. (Before seasonal adjustment, gasoline prices rose 3.3 percent in August.) The index for energy services was unchanged in August, with a 0.1 percent decline in the electricity index offsetting a 0.4 percent increase in the index for natural gas. Over the past 12 months, the energy index has fallen 23.0 percent, with the gasoline index falling 30.0 percent, the index for natural gas declining 32.7 percent, and the electricity index decreasing 1.2 percent.

Food: The food index rose 0.1 percent in August, with the index for food away from home rising 0.1 percent and the food at home index unchanged. Within the latter group, the index for fruits and vegetables fell 0.7 percent in August following a 0.3 percent decline in July. The index for dairy and related products fell 0.4 percent in August, its ninth consecutive decline, and the index for cereals and bakery products decreased 0.1 percent. Offsetting these declines were increases of 0.4 percent in the indexes for meats, poultry, fish and eggs and for nonalcoholic beverages and a 0.2 percent increase in the index for other food at home. The food at home index has declined 2.5 percent since its November 2008 peak. Over the past 12 months, the food index has risen 0.4 percent, with the food away from home index rising 3.0 percent and the food at home index declining 1.6 percent.

Transportation: Advances in the indexes for used cars and public transportation contributed to the increase. The used cars and trucks index, which was unchanged in July, rose 1.9 percent in August. The public transportation index rose 1.3 percent in August as the airline fares index rose 1.7 percent.

Housing: The lodging away from home index rose 0.5 percent in August after declining 2.1 percent in July. This increase drove an upturn in the shelter index, which rose 0.1 percent in August after a 0.2 percent decline in July. The rent index was unchanged and the index for owners' equivalent rent increased 0.1percent.

Medical Care: The medical care index rose 0.3 percent in August after a 0.2 percent increase in July, and the index for recreation edged up 0.1 percent. In contrast to these increases, the index for new vehicles fell 1.3 percent in August, partly due to "cash for clunkers" incentives. Also declining in August were the indexes for apparel, which fell 0.1 percent, and communication, which declined 0.2 percent.

Figure 2 shows the monthly changes in the seasonally adjusted CPI-U from 2002 to August 2009. Note the volatility over time. The key factor in these changes has been energy prices - primarily crude oil - which dropped from a high of over $145 per barrel in July of 2008 to a recent low of about $32 per barrel in December of 2008. By mid-2009, the price had slowly risen to about $70 per barrel and has been around that level since.


 
Figure 2 Inflation

Measuring 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

Other BLS Price Indexes

The Bureau of Labor Statistics publishes several other price indexes which can be used by consumers, government agencies and, private companies for budgeting and planning .

Producer Price Indexes (PPIs) are a family of indexes that measure changes in the selling prices received by domestic producers of goods and services. They formerly were referred to as Wholesale Price Indexes. When the PPIs are released, the news media will most often report the percentage change in the index for Finished Goods. Producer Price Indexes also can be used in escalation contracts. An Escalation Guide for Contracting Parties explaining the details is available.

Import/Export Price Indexes : The International Price Program measures change in the prices of imports and exports of nonmilitary goods between the United States and the rest of the world.

Employment Cost Trends : This program publishes quarterly statistics that measure change in labor costs (also called employment costs or compensation costs) over time; quarterly data measuring the level of costs per hour worked are also published. Indexes are available for total labor costs, and separately for wages and salaries and for benefit costs. Some information is available by region, major industry group, major occupational group, and bargaining status.

Contract Escalation : Consumer Price Indexes, Producer Price Indexes, and the Employment Cost Index may be used to escalate contracts.

International Labor Comparisons : Consumer Price Indexes as published by individual countries, unadjusted for comparability, as well as harmonized indexes for a smaller selection of countries, are available on the International Labor Comparison Tables page.

Disinflation

In late 2008, after several months of decreases in the price level, many economists and planners suggested that we faced a period of "deflation." Deflation is a sustained decrease in the general price level (CPI-U) resulting in an increase in the real value (purchasing power) of money. The key to the term deflation is that it is “sustained” or occurs over a significant period of time.  The changes in the price level over the past several months have been erratic, primarily due to fluctuations in food and energy prices. While food and energy have decreased, other prices have increased slightly – up 0.1 percent in July after an increase of 0.2 percent in June.

Perhaps, a more appropriate term to describe the recent price level trend is disinflation. Disinflation is used to describe a decrease in the rate of inflation. Disinflation can occur as a natural result of the downward business cycle, reflecting decreased demand for productive resources and goods and services. If the decrease is sustained, the effect is deflation.

The differences between deflation and disinflation are primarily time and consistency - the price level change from month to month versus the price level change over a year. Another key is the role of the more volatile food and energy prices. Factoring out food and energy, the so-called core rate of inflation, prices have continued to increase at a slower rate over time. The recent announcement is a good example of this distinction.

CONCLUSION

The consumer price index (CPI-U) increased by 0.4 percent in August, seemingly reversing a trend of downward price level change over the past year. The "catch" is that the very significant increase in energy prices was almost solely responsible for the overall increase in August. This is a good example for the debate over the use of the "heradline" or the "Core" CPI as a meaningful measurement of economic activity and change.

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. Others argue that to include the very volatile energy prices can mislead planners and government agencies when, for instance, energy prices increase and most other prices remain fairly constant.

ASSESSMENT ACTIVITY

Next, below answer the essay questions on the interactive notepad.


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

Critics of the CPI argue that the current measurement process of the CPI-U has flaws that affect the meaning of the numbers and their impact on consumers. The CPU-U measures only urban consumer prices. The CPI-U does not adequately account for changes in spending patterns over time, substitutions and quality changes. Is CPI an accurate assessment of the cost of living? 

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 the CPI is a meaningful measurement of cost of living.