How is inflation measured?

What is the Consumer Price Index?

The most popular way to measure inflation is through the Consumer Price Index, or CPI, which looks at the average change in prices that consumers pay for a basket of goods and services over time.

The contents of the basket is based on a survey of what families and individuals in urban or metropolitan areas are buying. The items are weighted based on importance and fall under eight groups: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication.

The CPI is used by various stakeholders for different reasons.

The president, Congress and the Federal Reserve use it to help determine monetary policies. It is sometimes seen as an indicator of how effective government economic policy is.

Some businesses and consumers use it as a guide to make financial decisions. When asking for raises at work, you at least want to match the rate of inflation so you can maintain your purchasing power.

The CPI also affects the incomes of millions of Americans. Cost-of-living adjustments made to Social Security beneficiaries and those in the military service are tied to the CPI.

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Where the CPI falls short

Yet the Labor Department acknowledges certain limitations with its popular price index.

The CPI, it says, may not accurately reflect what consumers in rural areas are paying. And it doesn’t break down prices for groups of people with very different spending habits, such as seniors or the poor.

There are also plenty of expenses the CPI does not cover, including changes in income taxes.

Analysts say one major pitfall of using the CPI to measure inflation is how it accounts for consumer substitutions to the basket of goods.

When the price of something — say an apple — goes up, consumers will often buy less of it or buy something similar in its place — like an orange — if the price is lower.

“But those changes month to month aren’t reflected in the CPI,” Mark Zandi, chief economist of Moody’s Analytics, said recently on the Inside Economics podcast.

If you’ve replaced a high-cost item with something more affordable, your personal CPI is going to look different.

“Generally in a rising inflation environment, the CPI probably overstates the case,” Zandi says.

An alternative measure of inflation: PCE

While substitutions aren’t reflected in the CPI, they do show up in a major rival: the Personal Consumption Expenditures price index, or PCE.

The PCE also takes all households into account, instead of just urban households, and is based on business surveys instead of consumer surveys, which some argue makes it more reliable.

The Federal Reserve certainly seems to agree, which is why a variation of the PCE is the central bank’s preferred index when making huge policy decisions. “Core” PCE makes it easier to identify concrete inflation trends by eliminating two volatile categories: food and energy.

The PCE increased 6.3% in April compared to the same month a year ago, according to the Bureau of Economic Analysis. Energy prices increased 30.4%, while food prices increased 10%. Excluding food and energy, the index for April increased 4.9%.

During the same period, the CPI was up 8.3%.

Zandi says Core PCE offers the best forward-looking reading of inflation.

“It does the best in terms of forecasting where you're headed,” he says.

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Could inflation be even worse?

Some analysts argue that inflation is actually a lot higher than what the Labor Department reports.

For example: Last fall, when the CPI was just over 5%, a widely circulated tweet suggested inflation was really about 15%, based on methods used before 1980. The debate pulled in public figures including clinical psychologist Jordan Peterson and former Twitter CEO Jack Dorsey.

The analysis that led to the 15% figure came under question — a recent New York Times review found inflation would be significantly but not dramatically higher — but it's true that the way the CPI is calculated has changed over time.

The Labor Department formerly calculated housing based on home prices, mortgage rates, property taxes and insurance and maintenance costs. Then, in 1983, it changed its formula to eliminate the investment aspect of homeownership.

Now, housing is measured in rents. To account for owner-occupied properties, the CPI uses what’s called Owners’ Equivalent Rent, which is the amount a homeowner would pay to rent their home.

However, it can be difficult to find rental housing that is comparable to owner-occupied homes, according to a report from the Brookings Institution.

“Predominantly renter-occupied neighborhoods are often geographically separate from owner-occupied ones — for example, a city center versus a suburb,” David Wessel and Sophia Campbell write in the report.

“Even within the same geographic area, housing characteristics can vary widely across rental and owner-occupied units — for example, the owner-occupied units in a neighborhood may be single-family homes, while the rental units may be multi-family buildings.”

CPI vs. PCE

Inflation has become one of the most pressing issues for consumers.

Seven in 10 Americans view inflation as the country’s biggest problem — more so than health care and violent crime, according to a Pew Research Center survey.

President Joe Biden says his administration is working to boost supplies of energy and lower the costs of everyday goods. Rising prices, he says, have been worsened by the war in Ukraine.

“The two challenges on the minds of most working families are prices at the pump and prices at the grocery store,” Biden said earlier this month. “Both of these challenges have been directly exacerbated by Putin’s war in Ukraine.”

But for Americans trying to make ends meet, inflation is personal. The CPI, PCE and other measurements are just proxies that might not align with what you’re spending — or not spending.

Cris deRitis, deputy chief economist at Moody’s Analytics, said on Inside Economics that consumers should take inflation numbers with a grain of salt.

“Your personal CPI is going to differ based on your own individual basket,” he said.