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Announcement

The consumer price index (CPI) during the month of December decreased by minus .1 percent (one-tenth of one percent). The rate of increase in the consumer price index over the past twelve months has been 3.4 percent.

In December, the core consumer price index, which excludes energy and food prices, increased by .2 percent (two-tenths of one percent). The core index has increased by 2.2 percent over the last twelve months.

Definitions of Inflation

Inflation is 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 measures the cost of a fixed set of goods relative to the cost of those same goods in a previous month or year. Changes in the prices of those goods approximate changes in the overall level of prices paid by consumers.

The core consumer price index is the average price of the same set of goods and services, without including food and energy prices, relative to the price of the set without food and energy prices in a previous month or year.

Data Trends

In December, the consumer price index decreased by -.1 percent, after decreasing .6 percent in November. In December, energy prices decreased for the third month in a row. Price indexes for transportation and apparel also fell.

The annual rate of change over the last three months was a minus1.6 percent and over the last 12 months, an increase of 3.4 percent. Annual inflation rates during all of 2002, 2003, and 2004 were 2.4, 1.9 and 3.3 percent.

While a number of news stories will focus on the rather rapid increase in the consumer price index, we should be cautious about placing too much emphasis on any one month change.

The core rate of inflation (increased by .2 percent in December) represents changes in the consumer price index without the influences of changes in the prices of food and energy, which can fluctuate widely from month to month. The increased December index compares to a .2 percent increase in the core rate of inflation in each of the previous five months. Core prices increased faster in the last three months than the overall index due to the rapid falls in prices of energy. The annual rate of decrease in prices of energy over the last three months was 35.2 percent.

Extra attention is given by forecasters to the core index as it tends to show more lasting trends in prices. This month's results provide some evidence that the increase in energy prices over the last several years has not significantly influenced rates of increases in all other prices. Still the rapid rise in energy prices may eventually have a significant effect on all other prices in the economy.

Graph 1

Figure 1 shows recent inflation data reported for each month. It is obvious that the monthly inflation figures change a great deal from one month to the next. However, the trend has been an increasing trend over the last five months. It is however difficult to tell what the trend over a longer period of time has been.

Graph 2

Figure 2 shows annual rates of inflation from the 1970s to now. Compared to the rates of inflation in the 1970s and much of the 1980s, the current rate of inflation is low. Few observers would describe the most recent rates, prior to this month, as high and they are not, when compared to those of the past thirty years. However, the recent rates have been increasing and that has caused some concern. See the most recent Federal Reserve case study and the exercises at the end of this case.

The Consumer Price Index

The seasonally adjusted consumer price index in December was 197.7. The price index was equal to 100 during the period from 1982 to 1984. The appropriate interpretation of the index is that prices in the market basket of goods and services purchased by the typical consumer increased from the 1982-1984 period to December 2005 by 97.7 percent. A typical consumer good that cost one dollar in 1983 now costs almost $2.00.

Inflation is announced and reported in newspapers and television news as percentage changes in the CPI on a monthly basis. For example, the CPI in December was 197.7, compared to 197.8 in November. The increase in prices from November to December was (197.7 - 197.8) / 197.8 = - .001. That means a monthly deflation rate of .1 percent.

To convert this into an approximate annual rate, you can simply multiply by 12. This provides us an annual deflation rate of (- .1) (12) = -1.2 percent.

Table 1
Month Price Level Monthly Inflation Rate
December 197.7
197.7 - 197.8 = -.001 or - .1%

197.8
November 197.8

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 $10.00, $20.00, and $30.00. The typical consumer purchased ten of each good.

In the current year, the goods' prices are $11, $24, and $33. Consumers now purchase 12, 8, and 11 of each good.

The CPI for the current year would be 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.

CPI Interactive Exercise

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. For more information on the Bureau of Labor Statistics, visit [EEL-link id='1222' title='www.bls.gov' ].

A Market Basket of Goods and Services

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. The relative importance of each of the categories of goods and services that included in the market basket are as follows.

Housing 42 % Recreation 6 %
Transportation 17 % Education and communication 6 %
Food and beverages 15 % Clothing 4 %
Medical care 6 % Other goods and services 4 %

Prices are collected through phone interviews and visits in almost 90 cities around the country. Almost 25,000 grocery stores, clothing stores, service stations, hospitals, and other retail stores are included. Fifty thousand families are interviewed.

For more information on the Bureau of Labor Statistics, visit [EEL-link id='1216' title='www.bls.gov' ].

CPI Interactive Exercise

Other Measures of Inflation

The GDP price index (sometimes referred to as the implicit price deflator). The GDP price index is an index of prices of all goods and services included in the gross domestic product. The index is a measure that is broader than the consumer price index.

The producer price index. This index measures prices at the wholesale or producer level. It can act as a leading indicator of inflation facing consumers. If the prices producers are charging are increasing, it is likely that consumers will eventually be faced with higher prices for good they buy at retail stores.