A Historical Look on the Consumer Price Index
The Consumer Price Index (CPI) has been used as an economic measure for over a century, guiding economic policies and financial decisions. It was introduced in the early 20th century to help American workers understand living costs during World War I. The U.S. Bureau of Labor Statistics (BLS) began calculating the CPI in 1913 to track price changes for a typical basket of goods and services in urban areas. Over time, the CPI has been updated to include a larger array of items, to try and reflect changing consumer habits. Today, it is used as a resource for policymakers, economists, and investors, as insights into inflation and the purchasing power of the dollar.
The General Impact of CPI on the Economy
The primary role of the Consumer Price Index (CPI) is to gauge inflation, which refers to the rate at which overall prices for goods and services increase, indicating a decrease in purchasing power. A rising CPI signals higher inflation, meaning the cost of living is going up. This impacts everything from household expenses to the interest rates determined by the Federal Reserve. When inflation is high, central banks may increase interest rates to slow down the economy, making borrowing costlier. On the other hand, low inflation could lead to lower interest rates to boost economic activity.
Today's Impact
In June 2022, the Consumer Price Index (CPI) peaked at 9.1%. Around the same time, the Federal Reserve responded with an aggressive rate hike plan. This often leads to an appreciation of the US dollar due to increased demand for USD-denominated assets, higher yield differentials, controlled inflation, boosted economic confidence, and currency carry trade dynamics. During periods of rising inflation and interest rates, there are usually concerns about slower economic growth and increased market volatility. As the Federal Reserve raised interest rates, the CPI quickly decreased. The strategy behind aggressive rate hikes is to "stomp" out inflationary pressures on the economy. This led to a steady decline in the CPI until around June 2023, after which it stabilized. The latest monthly inflation report showed a slight decrease from March's CPI of 3.5% to 3.4% in April.
Limitations
Let's point out some limitations of the Consumer Price Index (CPI). Although it was an important inflation indicator when first developed, its effectiveness has diminished over time. A major criticism of the CPI is that it often fails to reflect the true cost of living for contemporary consumers. Originally designed to measure the cost of living, the CPI's basket of goods and services may not accurately represent today's consumption patterns, particularly with the advent of new technologies. For example, the increasing use of telemedicine might not be adequately captured in the CPI, which still emphasizes in-person medical visits. This can lead to an underestimation of improvements in our standard of living due to telemedicine. Furthermore, the CPI employs a statistical method called hedonics, which adjusts prices based on changes in the quality and features of goods and services. For instance, if the price of a car increases from the previous year, the Bureau of Labor Statistics (BLS) might adjust this price upward to account for the enhanced enjoyment and functionality of the new car model.