The consumer price index is a price index for a basket of goods and services purchased by consumers. To construct it, the statistical bureau determines the relative importance (determining weights) of products and services in household expenditure in a given base year. After the basket composition is selected, the bureau monitors prices for the following years and calculates the price index.
Basket composition and weights in the index usually change after a few years. The aim is to reflect better the goods and services that consumers buy. For example, smartphones are not part of the household budget in the base year, so they are excluded from the basket of goods. However, because many consumers have already bought it, it is included in the latest revision.
Components and weights of goods and services vary between countries. In Indonesia, for example, the statistics bureau classifies products and services into categories such as food and beverage, housing, clothing, transportation, medical services, recreation, education, and communication. Also, the bureau categorizes it into three groups: core components, administered prices, and volatile goods components.
The following is an example of the consumer price index in Indonesia:
|Prepared Food, Beverages, Cigarettes and Tobacco||132.59||138.57||147.04||157.99||118.84||126.47||133.27||138.74||144.17|
|Housing, Water, Electricity, Gas and Fuel||119.79||123.95||128.1||136.07||115.55||119.41||121.68||127.93||131.04|
|Education, Recreation and Sports||117.86||123.94||129.16||134.21||110.37||114.75||117.88||121.81||125.65|
|Transportation, Communication and Financial Services||106.1||108.14||110.52||127.5||127.27||125.32||124.42||129.68||133.78|
|Consumer price index||125.17||129.91||135.49||146.84||119||122.99||126.71||131.28||135.39|
Calculating inflation rate from the consumer price index
The consumer price index is the most-widely-used price index to measure inflation. Its changes measure changes in the cost of living of the people, which is one of the objectives of government policy.
Alternatives of CPI are the GDP deflator and the producer price index. The GDP deflator measures all goods and services in the economy, including those not bought by consumers such as capital goods. Meanwhile, the producer price index measures the prices of production inputs.
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To calculate the inflation rate, we compare the percentage change in CPI over time. The formula is as follows:
Inflation rate = [(CPIt / CPI(t-1)) – 1] * 100%
Let’s take the data in the table above. The inflation rate in Indonesia in 2018 is equal to 3.1% = [(135.39 / 131.28) -1] * 100%.
Some items, such as food and energy, are very volatile. The price changes often do not reflect the fundamentals of demand and supply. Sudden shocks due to natural disasters or increased geopolitical tensions could result in drastic changes in the prices of these goods.
The consumer price index that excludes those items is called the core consumer price index (core CPI). Inflation based on core CPI refers to core inflation. Policymakers such as central banks usually focus on core inflation rather than CPI inflation.
Some central banks use CPI inflation, especially core inflation, as an anchor for monetary policy. When inflation rises sharply, the central bank will try to decrease it by raising interest rates. Likewise, when inflation is too weak or even deflation, the central bank responds by lowering interest rates.
In the inflation targeting policy, the central bank will try to meet a specific inflation target. For example, in Indonesia, the inflation target in 2019 is 3.5 ± 1%. The central bank will align its monetary policy to achieve these targets.
CPI inflation is a reference for determining wages. Companies usually raise wages to adjust for rising CPI inflation. CPI inflation is also used in financial markets such as Treasury Inflation-Protected Securities (TIPS) in the United States.