Inflation: what is the CPI and how does it work?

Inflation: what is the CPI and how does it work?

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The evolution of prices determines the consumption, investment and indebtedness decisions of companies and households, as well as the design of the economic, social, fiscal and monetary policies of a country.

Persistent inflation (generalized and prolonged rise in prices) or lasting deflation (continued fall in prices in the economy) have an adverse impact on society. The more stable the price level and, therefore, the value of money over time, the greater the well-being of society, since greater certainty is generated. For this reason, central banks have the objective of their monetary policy to keep inflation under control.

What is the CPI and how is it prepared?

The consumer price index (CPI) is a numerical indicator that serves to explain and summarize the evolution of the prices of a set of goods and services representative of household consumption.

It is a weighted index: the prices of each good or service that make it up have a different relative importance, depending on how much of the household spending is dedicated to the consumption of each good or service.

In order for the calculation of the index to allow prices to be compared over time, a reference base year is chosen, from which the prices of successive periods will be estimated and interpreted. But also, as time goes by, it is necessary to update that base year, so that the index maintains the representativeness of the household shopping basket, which evolves in accordance with the development of societies.

The Spanish CPI

In Spain, the origin of the CPI dates back to 1939 (p.18), when the National Institute of Statistics established the first system of cost of living indices for each province, in which the prices of between 95 and 139 items were considered. by province.

Since then, different base periods have been taken for the CPI. The last of them has been 2021, in which the updated shopping basket contains 955 items compared to the 977 it had in the previous base, established in 2016.

Some 220,000 prices are processed monthly to compile the CPI. The variations of this index from one period to another (from one year to another, from one month to the next, etc.) constitute a measure of inflation.

Both to choose the products that enter the shopping basket and to establish their weighting, the INE takes into account the data from the Family Budget Survey. This survey is carried out annually among 24,000 families and provides estimates of the expenses they make on consumer products.

If families buy more perishable food than packaged food, the price of perishable food should carry more weight in the cost of living measure. The same goes for other product groups, from insurance to electricity to education.

Currently, for the preparation of the CPI, the articles are classified into 12 groups with different weights that are updated each year according to the latest information from the family budget survey.

Weightings (in %) in the CPI of the Groups of Goods and Services that comprise it.
Source: Own elaboration based on INE data

We can observe the evolution of the CPI during the last two decades in the following table:

Evolution of the CPI in Spain between 2002 and 2022.
Source: Own elaboration based on INE data

If in 2002 the level of the index was around 70, in 2022 it is close to 110. In other words, in 20 years it has risen by around 57%. So, the accumulated inflation in the last two decades has been around 57%. In other words, the cost of living has risen and, to buy the same thing, you need 57% more money.

Considering that 20 years have passed, the increase is moderate. However, if incomes were not updated based on the index, citizens would have lost a lot of purchasing power.

If we compare the level of the CPI for the last available one-year period, we obtain the annual inflation rate. For June 2022, the CPI forecast in Spain has risen to 10.2%, the highest level since April 1985.

The percentage change in the price index between two periods is called the inflation rate. The inflation rate directly measures the loss of purchasing power although, as can be seen in table 2, prices do not always rise. For example, 2014 and 2002 ended with a negative inflation rate. That is, at the end of both years, more consumer goods could be purchased than at the beginning with a given amount of money.

The harmonized CPI

In order to compare inflation data with those of surrounding countries, especially those of the EU, since 1997 Spain has calculated the harmonized consumer price index, or IPCA, following the methodology and weights defined by Eurostat, the European statistical agency . This is the index that the ECB uses to guide its monetary policy.

The IPCA covers the consumption expenses made by all households within the economic territory of each EU Member State, whether or not they are residents there. For its part, the CPI contemplates the expenditure made only by residents, whether it is in the territory of the country or abroad.

Also, the weights of the different groups of goods and services are slightly different. There is even some difference in the products that both indices include in their respective consumption baskets. However, the values ​​of both are very close, since the similarity between them is very high.

core inflation

The concept of core inflation measures the evolution of prices after removing energy and unprocessed food from the index. These components are raw materials that are generally listed on international markets and are subject to high volatility.

Core inflation makes it possible to capture how the prices of the most stable products in the shopping basket are evolving and makes it possible to anticipate whether the rise in prices is going to be transitory or, on the contrary, whether it will be more persistent.

The core inflation forecast for May 2022 has been raised to 4.9%. This indicates that the inflationary pressures generated by the prices of energy and raw materials are being transferred to the rest of the products.

The CPI and its applications

The information obtained from consumer price indices and many applications in which this short-term indicator of the economy is used is very extensive.

The CPI is taken into account in reviews of salaries, pensions, insurance premiums, rentals, updates and investment valuations and, ultimately, in reviews of any contract or resolution where it is necessary to counteract the loss of the value of money and thus convert our unstable economic unit of measure into stable and homogeneous despite time.

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