Every month, economists and others look at the CPI to determine the rate of inflation in the economy. This measure is one of the factors considered when monetary policy is set. Indeed, inflation – as indicated by the CPI – is one of the items that the Federal Reserve uses when deciding what to do about its Fed Funds Rate. The Fed Funds Rate is used by banks to determine interest rates, including the yield that you get on your savings account. This chain of events that connects CPI to your savings yield is one of the reasons that it is important to understand why it could be a problem if CPI allows the government to underestimate inflation.
What is CPI?
First of all, it helps to understand what CPI is. CPI stands for Consumer Price Index. This inflationary indicator is also sometimes referred to as the cost-of-living index. CPI measures the month-to-month changes in the cost of a basket of products and services. Some of the items that are included in the CPI are food, housing, transportation, clothing, medical services, and education.
It’s not so simple, of course. Various stores, shops, offices and more are called each month, so that economic assistants at the Bureau of Labor Statistics can collect the current price of 80,000 products and services. All of that is averaged together, and if it appears that prices are rising, the government says that we are seeing inflation. However, if prices are falling, we are seeing deflation in the official view.
Because CPI is a measure of averages, though, your personal situation may not be reflected by the government’s view. Indeed, there might be wide disparities in real prices, depending on where you live. Another issue is that the government uses CPI to establish an inflationary trend. This means that the inflation you are experiencing in real life may not be reflected adequately by CPI.
Things get murkier when you look at core inflation. When figuring this, food and gas prices are taken out of the equation. And this is where things get really frustrating for savers who would like to see higher yields on their deposits to help offset some of the higher prices they are paying. The items that are most likely to fluctuate in price – and show higher increases – are removed from the discussion of core inflation. If you buy food or gas, you know that these items have a big impact on your monthly budget. But when considering monetary policy, the focus on core inflation and inflationary trends can mean that what “real” people are feeling every day could very well be underestimated by the CPI.
The way CPI is measured changed in 1996 after a 1995 report by the Boskin Commission that insisted that the CPI was overestimating inflation. As a result, two major changes were made in the equation used to determine whether price increases were actually happening:
1. Substitution: If the price of hamburgers was looked at as part of the CPI, but people began buying hot dogs as the price of hamburgers rose, then the item looked at would be hot dogs. Then, as prices on hamburgers fell a bit in response, there would be a switch back when people bought them again. Because of the substitution of something less expensive for something more expensive, it would appear that prices weren’t rising – even though they were.
2. Quality: Another issue is that the CPI is adjusted for quality changes. Supposedly, if you are paying a higher price for something that has improved in quality, you aren’t experiencing inflation. Even though you are, in practice, paying a higher price, the government CPI measure says it isn’t inflation, even though your purchasing power has been eroded.
You can see that, as a result of some of these adjustments to CPI, the government might actually be underestimating the rate of inflation – even if it only by a little bit. However, this still has an effect on how much savers are getting.
How CPI Affects You
Inflation obviously erodes your purchasing power. But that will happen whether or not the government recognizes it. The way the government measures inflation has an impact as well. In some cases, the CPI has a direct impact on your every day finances. Here are some things that are directly influenced by CPI:
- Annual adjustments on inflation-indexed annuities.
- Social Security payment adjustments (cost of living changes to benefits).
- TIPS and I-bonds are indexed to the CPI, so your payout on these investments could be affected.
- Movements in CPI are tied to the size of income tax brackets and personal exemptions, as is the standard deduction.
There is also an indirect effect: When the CPI is lower it is assumed that inflation is low, and that is considered a sign of a healthy economy. Wall Street also likes to see a “reasonable” inflation rate. When inflation is low, there is no need for higher interest rates, which reign in economic growth that appears to be getting out of hand. This helps businesses, but the lower interest rates mean that your savings yields are going to be rather low.
If the government’s measure of CPI is affecting the way it views inflation – and the way interest rates are set – and if that view is that there is an underestimation in the impact of inflation, it could very well be at the detriment of savers. Savers are penalized for their responsible behaviors by seeing lower returns on their deposits. Indeed, the low rates of return on many “safe” places for your money are influenced by the CPI.
On the flip side, though, people who are carrying debt are in a position to benefit. With lower rates, more of their payments go toward the principal, rather than to interest. If you have debt at this point in time, when the CPI is low, it’s a good time to focus on paying it down so that you get out of debt faster. That way, when the CPI indicates that inflation is an issue, and interest rates rise, you’ll be in a position to take advantage.