The CPI is calculated by taking the prices for a “basket” of specific items and comparing them to the prices for those same items in a selected year, known as the “base” year. If the inflation rate is two percent, this means prices overall are rising by about two percent a year. If prices fall, there is deflation. The indices are used by many organisations, including governments, that want to work out how much prices are changing over time in order to improve financial decision-making. Different countries may have their own incompatible versions, using individual definitions or sets of data.
The US’s Joseph Lowe has been called “the father of the CPI”. He developed the concept of a price index as a change in value of a selected basket of items in his 1823 study of finance, agriculture and trade. He mentioned the idea of linking earnings with rents as well as real interest rates. However, inspiration harks back to earlier attempts at devising price indices. In 1707, clergyman William Fleetwood in a book on pricing history estimated average price changes for Oxford University students over the previous 250 years. And in 1780, the US State of Massachusetts devised an index of Civil War soldiers’ pay so it could compare wages and adjust rates accordingly.
Evolution over time
The early 20th century saw theoretical underpinnings for the CPI solidify. Influences included a 1919 US shipping database covering 32 centres of shipbuilding and other industry, incorporating data back to 1913. Wages and some government payments can be index-linked to keep the purchasing power of these payments constant, rather than being eaten away by inflation.
CPI across the globe
The CPI for the United States is created monthly by the US Bureau of Labor Statistics. Eurostat releases a monthly Harmonised Index of Consumer Prices (HICP) for countries in the European Union. In the UK, the retail prices index (RPI) is still used for various purposes but has been superseded by the CPI. Learn how CPI is worked out across the OECD here.
One eye on the CPI
Even small rates of change in the CPI can add up over time, reducing the value – or purchasing power – of money. For example, if the inflation rate is two percent, an item priced at €100 today will cost €122 after 10 years. And those €100, if kept in cash, will only be “worth” €82. Inflation is to money like rust is to metal – as this short eZonomics video explains.