Sunday, November 9, 2014

The CPI: A Basic Introduction



If you live long enough, you will have the phenomenon where you go to a store and buy something, and you will realize that the price you paid now is much different from the price you remember paying for it as a youth. Live even longer and then you can regale the neighbor kids with all you memories of lower prices when you were their age. This is result of inflation, which is a general rise in the price levels. You are not necessarily better or worse off from inflation. Though that loaf of bread may have increased in raw value four times over your life, chances are that the amount you are paid for similar work has also increased in that time. 
Economists want more precision in their measures than the ranting of an parsimonious man. Instead, they base their judgments on the rise in the price level by putting together a list of things that people buy all the time for both goods and services.  This list is called a market basket. By watching the fluctuations in the change in prices of the market basket, economist can then compare what the prices of a standardized set of items have done in comparison with the previous year’s set of prices. Creating a ratio between the current year’s level of prices and the prices of the year you use as a baseline gives you a price index. Once you have a price index, you can compare the change in the price indexes and then you can come up with the rate of inflation (Krugman & Wells, 2013, p. 203). The change in the rate of inflation is important to track because there are many contracts tied to inflation so that the purchasing power of an individual is not lessened. Tax rates and social security benefits are some of the most visible examples of this. The federal government will usually increase the payment of social security benefits so seniors can afford the necessities of everyday living. Conversely, the IRS will peg also increase the income levels at which different tax brackets go into effect so as not to take too much away from the income of people who have more money through inflation.


The price level indicator that is used most in the United States is the consumer price index (CPI).The responsibility for creating the CPI falls to the Bureau of Labor Statistics, in the Department of Labor. They gather the prices of some 80,000 different distinct goods and services in 87 urban areas. If they cannot find the exact item, they substitute a new item and record the change in quality (‘How BLS Measures Changes in Consumer Prices”). The BLS has hundreds of employees, and they repeat this process every month to keep constant tabs on the shifting of the overall price levels, and the levels of prices in individual sectors such as housing and education (Krugman & Wells, 2013, p. 203). The measure of inflation as experienced by consumers is a lagging indicator, as the prices have already adjusted to whatever information that led to the increase, for example agricultural goods becoming more expensive in response to a drought (“Frequently Asked Questions”). There are other related indicators. There is a measure of the prices that suppliers are paying for their inputs, this is the producer price index (PPI). This indicator is closer to a coincident indicator because they firms are closer the signal and thus will react to price changes faster. There is also a competitive reason not to pass on price changes to consumers immediately; producers want their products to be competitive in the market. The PPP and the CPI move closely together though.
The relation between the CPI and overall growth in the GDP is somewhat difficult to unpack. The best explanation is that growth in the CPI reflects growth in the rate of inflation. Inflation is somewhat like salt in the human diet. Too much is detrimental, and not enough may be even worse. There is a goldilocks area where it is just right. The Federal Reserve targets a two percent rate in in inflation because any higher makes making future financial decisions difficult, and anything lower makes the specter of deflation raise its head (“Why does the Federal Reserve aim for 2 percent inflation over time?”). If the CPI contracts, this means that there has been a lowering of the price level, and thus deflation happened. This will mean that the GDP is on its way to shrinking. Conversely, if the CPI increases too much, the economy is over-heating with the proverbial “Too much money chasing too few goods”. The economy will be hot, and the GDP will be growing, but it is a signal that a bubble may be brewing and it could be cause for alarm in the long run. The graph below is a linear scale of the change in CPI from the Saint Louis Federal Reserve’s FRED website. Looking at the CPI for the last ten years, it is easy to see how during the Great Recession, the CPI first accelerated and then crashed. The current growth path is consistent with the steady recovery we have been in for the last five years. The forecast is that barring any outside shocks, the CPI shows that the trend is expected to continue.


Figure 1 From https://research.stlouisfed.org/fred2/graph/?graph_id=205692#


UPDATE: Changed Log to Linear referencing the graph.



References

Board of Governors of the Federal Reserve System. (2013). Why does the Federal Reserve aim for 2 percent inflation over time? Retrieved from http://www.federalreserve.gov/faqs/economy_14400.htm

Bureau of Labor Statistics. (2011).How BLS Measures Changes in Consumer Prices. Retrieved from http://www.bls.gov/cpi/cpifact2.htm
Bureau of Labor Statistics (2014). Frequently Asked Questions (FAQ). Retrieved from http://www.bls.gov/cpi/cpifaq.htm
Federal Reserve Economic Data. (2014). Consumer Price Index for All Urban Consumers: All Items, Index 1982-84=100, Monthly, Seasonally Adjusted Retrieved from https://research.stlouisfed.org/fred2/graph/?graph_id=205692#

Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers