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### INTRODUCTION

Each month, the U.S. Bureau of Labor Statistics (BLS) releases an estimate of the level of the consumer price index (CPI) and 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 lesson focuses on the September 17, 2010, BLS press release of data on the consumer price index for the month of August, 2010.

• 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

The September 17, 2010, Bureau of Labor Statistics (BLS) announcement reported the current level of U.S. consumer prices and the recent rate of inflation.  To better understand this data, here are a couple of important definitions:

What is the Consumer Price Index?

The Consumer Price Indexes (CPI), reported by the U.S. Bureau of Labor Statistics, part of the U.S. Department of Labor, 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.

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. Often, a one month increase in prices is referred to as inflation, but a longer-term upward trend of prices is a more accurate definition.  The most widely reported measurement of inflation is the Consumer Price Index (CPI).  For this announcement, the BLS reports the CPI-U - the consumer price index for all urban consumers.

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.

Discussion Question:   Is this definition what you thought inflation was?

The September 17, 2010, Bureau of Labor Statistics announcement

Consumer Price Index and Inflation: August - 2010

"The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.3 percent in August on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. (Before seasonal adjustment, the all items index increased 0.1 percent for the month.)  Over the last 12 months, the all items index increased 1.1 percent before seasonal adjustment."

The 0.3 percent monthly increases in consumer prices (seasonally adjusted) in July and August were the biggest monthly increases since August 2009.  The first half of 2010 saw a period of very little inflation, with three months of negative growth.  Is the return to some inflation, possible a 3.6 percent annual rate, a problem?   Reaction to the newest CPI figures has been fairly quiet.

"The energy index rose in August and, as in July, was the primary factor in the seasonally adjusted all items increase. All major energy components posted increases, with the gasoline index being the main factor. The food index, which declined in July, rose in August. The food at home index was unchanged while the index for food away from home increased."

A significant portion of the August inflation was energy prices.  Energy prices have sometimes fluctuated widely over time and month-to-month in recent times.  For that reason, the BLS also reports the "core" rate of inflation - minus energy and food (also more volatile).

The announcement identified some of the key factors in August's overall price change.

"The index for all items less food and energy was unchanged in August after increasing in each of the previous three months. This pattern mirrors the shelter index, which also was unchanged in August after rising in recent months. Posting increases in August were the indexes for medical care, used cars, and new vehicles, while the indexes for recreation and apparel declined."

Discussion Questions:  What price changes have you noticed over the previous few months?  Gasoline?  Food?  Other consumer goods?  What about housing or rent?

"Over the last 12 months, the index for all items less food and energy rose 0.9 percent, though the shelter component posted a 0.7 percent decline. The food index increased at a similar rate, rising 1.0 percent, with grocery store food prices up 0.8 percent. The energy index posted a somewhat larger increase, rising 3.8 percent with gasoline up 4.4 percent."

As usual, the key change factors have been energy and food prices.  Other prices have been relatively stable over the recent period.  Is there a reason to fear inflation?  Not according to the Federal Reserve and most of the media.  Some fear that, in the longer-term, new federal spending and huge government deficits will put too much pressure on prices - resulting in significant inflation.

The data in the initial announcement is “seasonally adjusted” or they “eliminate the effect of changes that normally occur at the same time and in about the same magnitude every year--such as price movements resulting from changing climatic conditions, production cycles, model changeovers, holidays, and sales.”

The BLS also reports the “not seasonally adjusted” price level data because “the unadjusted data are of primary interest to consumers concerned about the prices they actually pay. Unadjusted data also are used extensively for escalation purposes. Many collective bargaining contract agreements and pension plans, for example, tie compensation changes to the Consumer Price Index before adjustment for seasonal variation.”  Source: Seasonal Adjustment in the CPI .

From the BLS announcement:

"The Consumer Price Index for All Urban Consumers (CPI-U) increased 1.1 percent over the last 12 months to an index level of 218.312 (1982-84=100). For the month, the index rose 0.1 percent prior to seasonal adjustment."

"The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) increased 1.4 percent over the last 12 months to an index level of 214.205 (1982-84=100). For the month, the index rose 0.1 percent prior to seasonal adjustment."

"The Chained Consumer Price Index for All Urban Consumers (C-CPI-U) increased 0.9 percent over the last 12 months. For the month, the index rose 0.1 percent on a not seasonally adjusted basis. Please note that the indexes for the post-2008 period are subject to revision."

[Note: The level of the CPI-U in August was 218.312.  That means a market basket of goods that cost \$100 in 1982-1984 (the base year) now costs \$218.31.  That same basket cost \$215.83 in August of 2009.  If your monthly income has increased by about \$2.50 in the past year, your income has kept-up with inflation (at least with the price of this market basket of goods and services.)  Remember, this is a "sample" market basket.  If your spending habits are significantly different from the "average" the impact of inflation on you is different.   If you spent more than the average on energy in August, inflation affected you more.]

The BLS explains the meaning of “seasonally adjusted” data.

“By using seasonally adjusted data, some users find it easier to see the underlying trend in short-term price changes. It is often difficult to tell from raw (unadjusted) statistics whether developments between any 2 months reflect changing economic conditions or only normal seasonal patterns. Therefore, many economic series, including the CPI, are adjusted to remove the effect of seasonal influences-those which occur at the same time and in about the same magnitude every year. Among these influences are price movements resulting from changing weather conditions, production cycles, changeovers of models, and holidays.” Source: BLS, When Should I use Seasonally Adjusted Data?

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 2009 and \$52,000 in 2010.  His income increased by \$2,000 or 4 percent from 2009 to 2010. If the rate of inflation between 2009 and 2010 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 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, and funeral expenses)

Figure 1, below, shows the August price level changes for the several categories in the CPI-U "market basket."

 Figure 1:  Changes in CPI All Urban Consumers U.S. City Average August 2010 (Seasonally Adjusted) August 2010 12 months Aug. - Aug. All Items 0.3 1.1 Food 0.2 1.0 Food at home 0.0 0.8 Food away from home 0.3 1.2 Energy 2.3 3.8 Energy commodities 3.8 5.1 Gasoline 3.9 4.4 Fuel oil 0.9 10.6 Energy services 0.4 2.1 Electricity 0.2 1.6 All items less food and energy 0.0 0.9 New vehicles 0.3 2.3 Used cars and trucks 0.7 15.5 Apparel -0.1 -0.4 Medical care commodities 0.2 3.0 Shelter 0.0 -0.7 Transportation services 0.1 3.5 Medical care services 0.2 3.2

Figure 2, below, shows the changes in the CPI-U price level from 2002 through August, 2010.  Note the several periods of higher inflation, the periods of stability and the short periods of lower prices.  The key variable over this time has been the increases and decreases in energy prices, especially gasoline.

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. This 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. This 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 is the CPI 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.

 Figure 3:  How the CPI is Calculated? Index Point Change (1) CPI - Current Period 218.312 Less previous index 218.011 Equals index point change .301 Percent Change (1) Index point difference .301 Divided by the previous index 218.011 Equals 0.001 Results multiplied by one hundred 0.001 x 100 Equals percent change (2) 0.1 (1) Unadjusted (2) Adjusted percent change = 0.3%

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.

[Note: For additional information on CPI read the article "Measuring the CPI  " or take a look at BLS answers to Frequently Asked Questions About the CPI  .]

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 The 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. A fact sheet named Escalation Guide for Contracting Parties further explaining the PPI details is available.
• Import and Export Prices 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.
• Consumer Price Indexes (CPIs) 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 ComparisonsTables page.

### CONCLUSION

Consumer prices increased moderately in August, after a similar increase in July and decreases in May and June.   The annualized growth rate of 3.6 percent (assuming the growth rate remains constant for 12 months) does not seem to be enough to alarm analysts and planners, especially since much of the overall July-August increase was in energy prices.

Some say a little inflation is good - as a sign of growth and demand for goods and services.  What do you think?

Recently, some have feared a period of deflation - lower prices.  Why do you think they fear lower prices?

### ASSESSMENT ACTIVITY

Next, complete the following essay questions on the interactive notepad below.

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 BLS measurement 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.