According to the government’s Bureau of Labor Statistics (BLS) website, 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.” The website also states that the CPI “ is the most widely used measure of inflation.” In essence, the CPI, according to the government, is used to measure the rate of inflation and thus by extension attempts to quantify the cost and standard of living of Americans. The CPI uses a basket of goods and commodities in an attempt to measure price changes.
First and foremost, the CPI represents the biggest error many economists make when it comes to inflation: defining inflation as a general increase in prices. The original and accurate definition of inflation is the increase in money supply. Why is this important? Defining inflation as a general increase in prices would prevent economists from recognizing the root of the problem with an inflationary environment. An increase in money supply destroys the purchasing power of the dollar. An increase in prices does NOT necessarily mean that it was caused by monetary reasons. For example, the Los Angeles Clippers of the NBA announced that they will be increasing their ticket prices for the 2012-2013 season. NBA fans know that the Clippers are the most horrendous team in NBA history when it comes to team performance. In the past couple of seasons, the team’s performance, in terms of excitement and winning, has improved dramatically. Thus, this increase in ticket prices must be because of inflation right? If you go by the “mainstream” definition, then the Clipper ticket prices is indeed an example of inflation. But let’s use some common sense. The main driver behind the rise in Clipper ticket prices is because of the increased demand for them, not because of an increase in money supply. In a nutshell, inflation is not a price phenomenon, but rather a monetary phenomenon. Thus, the CPI, by its nature of measuring price increases, is not an accurate measure of inflation (when defined accurately).
Secondly, the CPI, specifically the “core” CPI, is quite deceptive when used as a price index. The core CPI is reference often by the Federal Reserve when it announces its monetary policies. As previously mentioned, the CPI consists of a basket of goods and commodities in order to measure price levels. However, the core CPI excludes food and energy prices (the two most important goods for consumers). How can you claim to have a credible price index when you EXCLUDE the two most important consumer goods!? Economists cite the distortion of the CPI due to their volatility as the reason behind the exclusion. The problem of volatility can be easily solved by using the trailing 12 months CPI (NOT the trailing 12-months “core” CPI).
Unfortunately, the CPI is still used by economists and media pundits as a measure of inflation. But you needn’t be fooled. The next time you see someone defining inflation as an increase in prices, just remember the Clippers.