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Know Your Numbers: Consumer Price Index

Most releases of economic data -- whether it's the Federal Reserve's index of industrial production, America's gross domestic product, or the latest employment numbers -- don't seem to have much impact on the lives of ordinary people. But nearly all Americans care a lot about prices. From Wal-Mart (NYSE: WMT  ) to Priceline (Nasdaq: PCLN  ) , from Costco (Nasdaq: COST  ) to eBay (Nasdaq: EBAY  ) , consumers are willing to go to great lengths to find bargains. And when prices rise, consumers get upset. They'll look to Canada for affordable medicine and even steal gasoline when prices at the pump reach record highs.

Given the importance of prices to Americans, it's not surprising that one of the most watched economic indicators is the Bureau of Labor Statistics' monthly release of its consumer price index. The CPI not only provides a way of measuring the change in overall price levels over time, but also serves a host of other functions that have a huge impact on a variety of economic transactions.

The basic concept
The consumer price index is designed to show changes in the prices that consumers pay for goods and services. To calculate the CPI, the Bureau of Labor Statistics puts together a representative basket of goods and services that reflects typical consumer behavior. The BLS then collects price data from about 23,000 retail stores and service providers from 87 urban areas across the nation. To assist in the calculation of housing costs, the BLS consults with more than 50,000 landlords and tenants to determine the typical payment level for rental property.

The basket of goods and services used for measuring the CPI consists of items that cover the whole spectrum of normal consumer expenses. That basket is broken into several major categories, including food, housing, clothing, transportation, medical care, education, communication, and miscellaneous goods and services.

In calculating the CPI, the BLS applies weights to each category that reflect the relative importance of the category to the typical consumer. For example, in the broadest measure of the CPI, shelter costs compose more than 42% of the index, with transportation making up about 17%, food and beverages about 15%, and medical care about 6%. Each category has further breakdowns; for instance, food costs for the home are compared against the cost of eating out, with eating at home having a slightly higher weight in the index. Likewise, gasoline costs are a subset (about one-quarter) of typical transportation expenses.

Once the components of the index are calculated, seasonal adjustments are made, but both adjusted and unadjusted data are available in the report. Additional adjustments are made to the raw price data as well, so as to reflect changes in the quality of the items that the index used in getting relevant prices. As a simple example, assume that a new product came to market that allowed consumers to do the same work with just half the amount of a previously available product. If the new product came in containers the same size as the old product, consumers might therefore be willing to pay twice the price of the old product. But such a development would not represent an increase in price, since consumers would be paying the same amount per unit of work. So the BLS would make an adjustment to recognize the qualitative value of the new product.

That's a simplification of the actual process the BLS uses. To make more precise calculations, the bureau uses a statistical technique known as hedonic regression modeling to determine the relative importance of the many characteristics that consumers consider in assessing the value of a particular good.

Much of the bureau's hedonic regression modeling to date has focused on clothing. Since clothing styles and fashions are changing constantly, the BLS considers it critically important to have a thorough understanding of the factors that add value to a particular piece of clothing, rather than simply substituting this year's most popular suit for last year's in calculating the index. Although the BLS says quality considerations have the largest impact within clothing, it is also conducting further research into applying hedonic regression models to other types of goods, such as computers and other technology goods.

As you can see, a great deal of work goes into calculating the consumer price index. While many other statistical measurements merely require adding up reported values from survey respondents, calculating the CPI involves performing complicated statistical manipulations for making suitable comparisons between various time periods.

As the second part of this article discusses, the CPI has its critics. Some say the bureau's methods fail to reflect economic reality -- a weighty criticism, given the importance of the CPI to a wide range of transactions involving individuals, businesses, and government entities.

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Priceline, Costco, and eBay are Motley Fool Stock Advisor recommendations. Wal-Mart is a Motley Fool Inside Value pick.

Fool contributor Dan Caplinger is always the first to notice when gas stations change their prices. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy doesn't cost you a cent.


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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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