The highs and lows of the economy affect people and markets in a variety of ways. While some sectors may be thriving, others may be sluggish. One economic indicator used to gauge the state of the American economy is the Consumer Price Index (CPI), which measures the rate of inflation in the U.S.
Inflation, which is defined as a rise in the average price level of all goods and services, can have a significant impact on the American economy and your financial affairs. Understanding the CPI, and the ways it measures inflation, can provide a strong foundation for understanding not only market and economic swings, but also the ways in which fiscal and monetary policies affect America’s finances, and your own. Let’s take a look at the information used by the U.S. Bureau of Labor Statistics (BLS) to compile CPI data.
Determining the Market Basket
Each month, the BLS surveys prices for a "market basket" of goods and services in order to create an economic "snapshot" of the average consumer’s spending, which is quantified as the CPI. Actual expenditures are classified
into more than 200 categories and eight major groups:
- Food and Beverages: common groceries, alcoholic beverages, and full-service meals
- Housing: rent, furniture, and utilities
- Apparel: clothing, shoes, and jewelry
- Transportation: vehicle lease and purchase costs, gasoline, auto insurance, and airfare
- Medical Care: doctor’s visits, hospital care, and prescriptions
- Recreation: cable television, pets, events, and sporting equipment
- Education and Communication: school tuition, postage, telephone service, and computer equipment
- Other Goods and Services: tobacco, haircuts, personal services, and funeral expenses.
Because the CPI assesses expenditures in these fixed categories, it is a valuable tool for comparing the current prices of goods and services to prices last month or last year.
Interpreting the CPI
As a measure of inflation, the CPI has three main functions. First, the CPI serves as an indication of the health of the economy and the effectiveness of government policy. To a certain extent, some inflation indicates a healthy economy; however, too much inflation, or no inflation at all, can indicate economic trouble. In fact, one of the primary U.S. economic policy goals is to maintain an inflation rate ranging from 1% to 3% each year.
If there are constant fluctuations in the CPI, Congress and the Federal Reserve Board (the Fed) will take measures to control the amount of inflation and stimulate economic growth. As a result, business executives, labor leaders, and private citizens may change their spending and saving patterns. For example, the Fed may attempt to curb rising inflation by raising short-term interest rates; this increase in the cost of borrowing money is likely to slow personal and business spending. Conversely, if the economy is not growing, the Fed may attempt to stimulate growth by lowering short-term interest rates. Lowering the cost of borrowing may trigger increased spending among businesses and individuals.
As a second function, the CPI helps determine the "real" value of a dollar over time by removing the effects of inflation. As prices increase, the purchasing power of a dollar decreases. Thus, more dollars are needed to purchase the same amount of goods and services. Comparing inflation-free wages and prices allows economists to determine the actual earning and spending patterns of the American consumer, including what percentages of money are being saved or spent in certain areas.
Lastly, the CPI is used as a means of adjusting salaries and government benefits to account for price changes. For example, as a result of collective bargaining agreements, the wages of over 2 million workers increase according to the amount of change in the CPI. The CPI is also used to determine the benefits of almost 80 million people covered under government programs, including Social Security beneficiaries, military and Federal Civil Service retirees and survivors, and food stamp recipients. In addition, changes in the CPI can be seen in the price of school lunches, as well as in rents, royalties, alimony payments, and child support payments as determined by private firms and individuals. Finally, the CPI has been used to adjust the Federal income tax structure to prevent increases in taxes caused solely by inflation.
For More Information
Inflation can have a serious impact on the American economy as it affects both government policy and the spending and saving patterns of businesses and individuals. Understanding and following changes in the CPI can help you understand how the value of the dollar changes and estimate how inflation may affect your future plans. The U.S. Department of Labor (DOL) publishes current information on the CPI each month through the BLS. For more information, visit www.bls.gov/cpi. $
Current tax law is subject to interpretation and legislative change. Tax results and the appropriateness of any product for any specific taxpayer may vary depending on the particular set of facts and circumstances. The information contained in this newsletter is not intended as tax, legal, or financial advice, and it may not be relied on for the purpose of avoiding any Federal tax penalties. You are encouraged to seek such advice from your professional advisors. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Written and published by Liberty Publishing, Inc. Copyright © 2010 Liberty Publishing, Inc.