What Is CPI?
The consumer price index (CPI) is widely misunderstood (see Common Misconceptions About Government Statistics) and many people just plain don’t trust it (see Is CPI Manipulated?). Why exactly does this statistic elicit such irrational hatred? I think a lot of it has to do with a general misunderstanding of exactly what CPI is meant to measure. So, what is CPI?
CPI Is A Price Index, Not An Inflation Index
According to official BLS literature,
“The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”
That is, the CPI is a measure of prices of a specified basket of goods, which is meant to approximate the overall price action of the broader economy. This is only an approximation, however, and is only likely to be accurate over long periods of time. Measured over a 20 year period, the CPI is likely to be very close to actual monetary inflation. However, over shorter time periods, such as a year or even shorter, all bets are off. The reason for this short-run discrepancy is that many factors can affect the price of goods and services that have nothing to do with the overall money supply. For example, was the run-up in gas prices last year inflation or was it merely supply and demand? In retrospect, it was obviously a supply-and-demand issue, not an inflation issue.
While it’s true that over the long term price inflation tends to track monetary inflation, in the short term they can and often do become decoupled. According to some sources, the U.S. money supply is growing at somewhere around a 9-10% clip. By contrast, what is the current CPI? As of the end of 2008, it stood right at 0%, meaning there was practically no inflation in 2008.
Many people interpret this discrepancy as proof the government is lying to its citizens, but I think that’s silly. Systemic price increases and increases in the money supply go hand-in-hand in the long term, but it would be unreasonable not to expect there to be short-term divergences. Markets, after all, often take a long time to process and react to new realities.
CPI Is A Nation-Wide, Aggregate Measure
One of the simplest and most important reasons CPI numbers might not match your experience exactly is that CPI is a nation-wide, aggregate measure. That is, it is averaged over all geographic regions and doesn’t apply exactly to any one of them. New York City, Helena, Montana, and Phoenix, Arizona, and rural Kansas are likely to have very different economies with exposure to vastly different industries, commodities, and costs-of-living. It is entirely possible, indeed likely, for different regions to have different inflation rates. About a year ago, I wrote a post entitled Calculate Your Personal Inflation Rate that explains this concept and allows you to calculate your own rate personally. The calculate no longer works (it was hard-coded using January 2008 numbers), but the post is worth a read as a broad overview.