Meltdown 101: How is the CPI calculated, and why?

[November 20, 2008]  NEW YORK (AP) -- The Consumer Price Index, the nation's best-known inflation gauge, plunged in October thanks to a record drop in gasoline prices.

But if prices still seem high to you, you're right.

October's 1 percent drop in consumer prices was the largest monthly decrease in the 61-year record of comparable data, but that doesn't mean prices are plummeting over the long term. Overall prices are still 3.7 percent higher than they were last October, and the difference is even greater in some categories. Gasoline costs 12 percent more than it did a year ago.

Tracking all this is no easy task. Critics say the CPI, as currently calculated, doesn't reflect actual inflation -- but they're divided on whether it understates inflation or overstates it.

Here are some questions and answers about the CPI.

Q: How is the CPI calculated?

A: The Bureau of Labor Statistics, which calculates the CPI, did quarterly surveys of 7,000 families from around the country in 2005 and 2006, asking about their spending habits and collecting information on frequently purchased items. Another 7,000 families kept detailed diaries listing everything they bought during a two-week period.

That information was used to create a list of the most commonly purchased goods. It was also used to weight purchases according to their share of household budgets, ensuring the CPI accurately reflects the effect increases in those items have on consumers.

Housing is the largest component of household spending, with a 42 percent share. Next is transportation, at roughly 17 percent, followed by food, at around 15 percent.

The bureau's data collectors, called "economic assistants," make monthly visits or calls to 23,000 stores and service providers, from grocery chains to doctors' offices, collecting prices on thousands of goods and services in 200 categories, using definitions that don't vary. The items whose prices the bureau tracks include new cars, airfares, baby food, pet food, uncooked ground beef, milk, shoes, eyeglasses, postage, tools, tires and books.

Economic assistants also call or visit 50,000 landlords and tenants to ask about rent.

The CPI also includes city services, such as water, sewer and trash collection. Sales taxes are included, but income taxes and investments, such as stocks, bonds and life insurance, are not.

Q: What's the difference between core inflation and overall inflation? Why do two different figures exist?

A: Overall inflation is just what it sounds like: the rate of inflation for everything on the list.

Core inflation strips out food and fuel prices, which are volatile. Without food and fuel, the CPI is supposed to give a better read on the "underlying" rate of inflation.

But critics say core inflation gives an overly rosy picture of what's happening to prices during times when food and energy prices are soaring, such as this summer. After all, consumers don't get to strip out those costs from their expenses.

Q: What could distort the CPI?

A: Simple product changes are factored in. If, say, a package of coffee is $5 a pound in August, but the package shrinks and costs $5 for 14 ounces in September, the bureau calculates its cost per ounce and the effective price increase from the new package.

Larger product changes are more complicated. If a laptop gets thinner and lighter, but costs the same, the bureau might calculate its price as declining, since consumers are effectively getting a better computer at the old price. Some critics contend that such "price decreases" understate inflation, because they don't really reflect what consumers spend at stores.

Others argue that the CPI doesn't reflect such technological improvements often enough and, as a result, overstates inflation. They point to advances in medical techniques such as laser eye surgery, saying quality improvements mean consumers are effectively getting a better service at a lower price.

Home expenses are another tricky area. Because the CPI excludes investments and because owning a home is partly an investment, the bureau, in 1983, began calculating home costs using rent as a base, computing what homeowners would pay to rent housing equivalent to what they own. The problem: When home prices were soaring, rents did not. Many economists say the CPI understated housing costs during this period.

Q: What is the CPI used for?

A: While there are other measures of inflation, one of the things that makes CPI so popular is that it's used to set cost of living adjustments for people in federal entitlement programs.

Roughly 48 million Social Security recipients, 22 million people on food stamps and 4 million military and federal civil service retirees and survivors get cost of living increases tied to CPI. Another 2 million union workers get wage increases tied to the CPI, according to the Bureau of Labor Statistics. Changes in CPI also affect the cost of school lunches for roughly 27 million children.

All the legislated uses of CPI use the full "headline" number, not the "core" inflation measure that excludes food and fuel.

[Associated Press; By ELLEN SIMON]

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