Inflation and the Consumer Price Index: How They Work and How They Affect You

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Rising prices have been the big economic story of post-vaccine America, and inflation has evolved from a nagging nuisance to the most severe decline in the dollar’s buying power in more than 30 years. Televisions cost 10.4% more than they did 12 months ago. Infant and toddler clothes are up by 7.6%, used vehicles are up by 26.4%, and, perhaps most unforgivably, bacon costs over 20% more than it did last year.

Still Affordable: 4 Costco Items That Have Remained Cheap for Years
See: As ‘Inflation Wipes Out Real Gains,’ How Much of a Raise Will You Need in 2022 To Keep Up?

So, how do we know all this right down to the decimal point? Because the consumer price index (CPI) gives economists a yardstick to measure the rate of inflation.

The CPI Is a Useful Tool for Analysts and Regular People, Alike

Most people know by now to factor rapidly rising prices into their holiday shopping budgets this year — the story of inflation has been all over the news. In early November, the news got worse when the Bureau of Labor Statistics (BLS) published its monthly CPI report for October — the CPI is a lagging indicator, which means its data is based on something that already happened.

Make Your Money Work for You

The November CPI report showed that prices surged by 6.2% between last October and this October, the biggest one-year jump since 1990.

Learn More: The Relationship Between Inflation and a Rising Minimum Wage

That news had an impact on the daily lives of real people, who were budgeting for Thanksgiving, the winter holidays and all the party-hosting, gift-giving and travel that goes along with it just as the report arrived.

Because of the report, people knew that renting a car would cost nearly 40% more than it did this time last year, that gas would be nearly 50% more expensive, that hotels would cost more than 25% more, and that they could expect to pay nearly 20% more for a turkey this Thanksgiving.

So, how does the CPI measure inflation, an economic phenomenon that reduces the purchasing power of currency over time?

Read: Understanding Interest Rates — How They Affect You and the US Market

The CPI Tracks the Price of All the Things That People Buy

The CPI presents economists with an impressively accurate measure of the inflation rate by tracking the average change over time in the prices of thousands upon thousands of commonly purchased goods and services. It groups those goods and services together in “baskets,” which allows economists to see, for example, how the price of footwear, furniture, utilities, transportation or food has changed over time.

Make Your Money Work for You

Find Out: Understanding the Differences Between Inflation, Deflation & Stagflation

Prices rise naturally over time, even in the healthiest of economies, and inflation can be a natural byproduct of expansion and growth. Too much inflation, however, leads to economic contraction as people can no longer afford to purchase as much as they could before with the same amount of money.

The BLS’ monthly CPI report alerts economists to emerging patterns in the rate of inflation, as the bombshell report on the October inflation rate did in November. Just as steep increases in the CPI over short periods of time tell economists that inflation is on the rise, the CPI can also alert analysts and policymakers about the potential for deflation, which occurs when prices fall across many different economic baskets.

See: Why Supply and Demand Is Important to You and the Economy

CPI Can Be Altered To Be More General or More Specific

So, in summary, the CPI does not affect or change inflation, it merely measures the rate at which inflation rises or falls — but there’s more than one yardstick. The most widely followed version is CPI-U, a general index that tracks price hikes that affect all urban consumers, about 80% of the population. CPI-W tracks prices that affect a more specific population — urban hourly wage earners and clerical workers.

Also, the CPI can be modified to remove energy and food, whose highly volatile prices can skew the CPI’s results. That model is called core CPI and what it measures is called core inflation — the inflation rate of everything except for food and energy.

This article is part of GOBankingRates’ ‘Economy Explained’ series to help readers navigate the complexities of our financial system.

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About the Author

Andrew Lisa has been writing professionally since 2001. An award-winning writer, Andrew was formerly one of the youngest nationally distributed columnists for the largest newspaper syndicate in the country, the Gannett News Service. He worked as the business section editor for amNewYork, the most widely distributed newspaper in Manhattan, and worked as a copy editor for TheStreet.com, a financial publication in the heart of Wall Street's investment community in New York City.

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