From groceries and clothing to haircuts and housing, what we spend on and, more importantly, how much we spend says a lot about the overall economy. All this data is tracked by a tool called the Consumer Price Index. So, how is this index calculated and what can it tell us?

This is the Consumer Price Index: Unpacked.

The Consumer Price Index, or the CPI, tracks changes in the prices of goods and services over time. It dates back to World War One. Prices were increasing rapidly and wages needed to be adjusted. So, in 1921, the U.S. government began publishing the index across major cities every year. A century later, the CPI is the most widely cited barometer of living costs around the world.

It includes thousands of everyday items across various spending categories, and each item is weighted according to its relative importance. For instance, housing is a key component of the CPI as it typically accounts for a large chunk of the average consumer's expenditure.

By monitoring changes in the index, governments can work out if the cost of living is rising or falling. This makes it a useful gauge of inflation and deflation. Most countries update their CPI every month. Every so often, the basket is updated according to consumer buying patterns. In early 2023, the U.S. increased the weight of household furnishings in its CPI to reflect that people were spending more time at home during the pandemic.

The overall CPI figure is often referred to as the Headline CPI. However, economists and policymakers tend to look at Core CPI which excludes food and energy data. This is because the costs that feed into these components, like oil prices, can be quite volatile from month to month.

While the CPI is the most comprehensive source of consumer prices, it's not perfect and doesn't allow for variables. For instance, while it shows aggregate spending, it doesn't reflect the personal experiences of individuals and households. It's also based on the spending patterns of urban consumers and doesn't take into account the buying habits of those living in suburban or rural areas.

What's more, the index doesn't consider the effects of substitution or the fact that when an item becomes more expensive, people tend to seek out more affordable alternatives.

Despite these limitations, the CPI remains a handy tool for governments, businesses, and society at large. In the U.S., the Federal Reserve uses the CPI to calibrate monetary policy and set interest rates while other government agencies use it to calculate benefit payments and income tax brackets. Employers also often look to the CPI when adjusting wages in line with the cost of living.

All in all, the CPI is an important metric that informs many major decisions and tells us a lot about the health of a country's economy.