What Are Inflation and CPI?

To know how good of a metric CPI is for measuring inflation, we should start by understanding both inflation and CPI. Economists belonging to the Austrian school of thought in economics, most famous among them being Friedrich Hayek and Ludwig von Mises, considered inflation as the rise in money supply. 

Where you can define the supply of money as the total amount of cash and cash equivalents available to individuals and institutions. While mainstream economists generally consider inflation as a rise in the aggregate price level. These two definitions are related to each other as the monetarist school of economics famously represented by Milton Friedman has established that the root cause of changes in price level are changes in the money supply.

Consumer price index (CPI) has been defined as a measure for price level. Thus CPI is an average of prices. To measure CPI one defines a basket of goods and services to represent what an average consumer is buying. The price of the content of this basket is defined as CPI. Percentage change in the value of CPI is considered to define inflation rate. 

In the US, the Bureau of Labor Statistics (BLS) has had the duty of measuring and publishing CPI for more than a century. It is customary to normalize the value of the basket of goods and services a typical consumer needs to 100. So that the normalized value for each good or service in the basket represents the percentage of that good or service in the basket.

Currently the most important category in CPI is housing with a weight of 42%, which includes shelter with a weight of 33%, which in turn includes rent of primary residence at 7.4%. Shelter also includes Owners’ equivalent rent of residences with a weight of 24%, which in turn includes Owners’ equivalent rent of primary residence with a weight of 23%. Another important category included in CPI is transportation with a weight of 18%, which includes private transportation with a weight of 17%, which in turn includes New and used motor vehicles with a weight of 9%.

Also among the most important groups of goods and services affecting CPI are food and beverages 14%, which includes food 13%, which itself includes food at home 8% and food away from home 5%. Finally Medical care with a weight of 8.8% is an important component of CPI. Medical care includes professional services with a weight of 7%. Recreation at 5% and Education and communication at 6.5% are other categories of services included in the CPI. The following table shows the most important expenditure categories in the CPI basket.

Important Categories of Expenditure and Their Weights in CPI

Does CPI Really Represent Inflation?

When money is created, generally it is not distributed evenly among members of the society. Those who have more get more from the new money and the spending of new money differs among different socioeconomic groups. Lower income groups would mostly spend their added income on necessities of life which are present in the CPI basket. Higher income groups would use most of their extra money for investment purposes.

They buy real estate and stock. This uneven distribution of new money together with the uneven expenditure by rich and poor causes inflation in investables to be much higher than inflation in consumables. Investables are excluded from the CPI basket as they are not consumed by consumers. It is true that we do not consume houses or stocks in our daily lives; but it is my dream to see my kid playing in my own house rather than a temporary rented home.

Also to have peace of mind for my retirement, I need to own some stocks in my retirement plan. So investables important to my life are excluded from the CPI calculation. Thus changes in the CPI which are reported by the government as inflation is biased to show inflation lower.

There is another issue with CPI values reported by BLS. CPI as initially defined by economists and used by BLS was the price of a basket of goods and services relative to those prices in the base year. But as time passed, the government decided to allow the composition of the CPI basket to change. Currently, each December BLS publishes the composition of the CPI basket for next year. This change also gives CPI a bias toward lower values.

To understand how this change affects CPI let us consider a simplified example. Consider a housing market composed of rooms for rent, bachelors for rent, 1 bedroom apartments for rent, 2 bedroom apartments for rent and 3 bedroom apartments for rent. Consider the prices for last year and this to be as listed in the table below. Also consider the portion of population living in each type of housing to be as reported in the table.

Housing Stat for a Hypothetical Economy

In this example as you see rents are increased by 20%. But another change in this economy is that the consumption pattern has changed. Some people who could not afford new prices are opting for smaller living spaces. This change in consumption pattern would be reflected in the CPI basket.

So the rental component of the CPI basket for last year would be (.25*900+.25*1200+.25*1500+.25*1800) = 1350, while the rental component of CPI basket for this year would be (.125*840+.25*1080+.25*1440+.25*1800+.125*2160) = 1455. So current CPI method used by BLS suggest an inflation rate of ((1455-1350)/1350)*100% = 7.8%; while prices have increased by 20%.

This is an extreme example; but it serves well to show that official CPI numbers are measuring the changes in what people spend but not necessarily the changes in price levels. In other words CPI is geared toward measuring cost of living rather than inflation.

To conclude, I should say the government can define inflation as changes in CPI, but if you wish to know the change in the purchasing power of your dollar denominated savings, CPI is far from ideal.