What is CPI?
CPI stands for Consumer Price Index, which is an index maintained and reported by the U.S. Bureau of Labor Statistics.
The Consumer Price Index is made up to two primary figures for each reporting period:
- Index: The total average cost urban consumers pay for a predefined basket of goods and services.
- Percent Change: The percentage the index changed from the last reporting period, which is often referred to as the rate of inflation (or deflation if the index shrinks).
For more information about the consumer price index, please visit the official CPI website.
Why is the Inflation Rate Important?
Knowing the past rate of inflation is useful for predicting future inflation. And future predictions are most commonly used in the following ways:
- Retirement Planning: In order to prepare for your retirement, you need to factor in inflation to predict how much you will need to earn in the future to afford your present lifestyle.
- Adjusting Money Values: If you borrow or lend a sum of money today, the forecasted rate of inflation will help to determine what that sum will be worth when it is returned to the rightful owner.
- Cost of Living Adjustments: In order for you to maintain your current standard of living, your annual salary or gross wages will need to keep pace with the annual rate of inflation (see the Salary Inflation Calculator to see what your raise needs to be this year).
In the case of retirement planning, if you determine you will need $50,000 (in today's dollars) in annual retirement income 20-years from now, and you estimate the average inflation rate will be 2.5%, the effects of inflation will mean you will need to earn $81,930.82 then in order to buy what $50,000 will buy today.
As for adjusting money values, if you were to lend me $1,000 today with the promise that I will pay you back in 10 years, and you anticipate a 2.5% inflation rate, when I pay you back, your buying power will have been reduced to $781.20. So to avoid losing buying power on the deal, you would need to insist that I pay you $1,280.08 at the end of the 10-year loan.
Finally, if you are not receiving annual cost of living raises equal to or greater than the rate of inflation, your buying power will decrease even if your wages are increasing.
What Causes the CPI to Rise or Fall?
While there are many factors that influence the CPI, the predominant factor is the state of the economy.
If the economy is shrinking, consumers have less money to spend, and therefore businesses are forced to reduce their prices to get rid of their excess supply of products. Widespread shrinking prices often cause the CPI to shrink (deflation), as was the case in 2009. If the federal reserve board determines the economy is shrinking too fast, it will lower interest rates to encourage new construction and innovation.
On the other hand, if the economy is growing, consumers have more money to spend. Therefore businesses tend to increase their prices to compensate for the increased demand (build new factories, hire more workers, etc.). Widespread price increases typically cause the CPI to rise (inflation). If the federal reserve board determines the economy is growing too fast, it will raise interest rates to discourage new construction and innovation.
Just a glance of the historical Consumer Price Index, and you will be able to quickly tell when the economy was shrinking (negative percent change) and growing the fastest (higher positive percent changes).
