Lately, a lot of people started looking closely at inflation because it has recently reached a 40-year high. Inflation is a metric that measures changes in the prices of different goods and services that are tracked with a Consumer Price Index (CPI). Apart from having a detrimental effect on the economy, the inflation rate affects individuals in different ways. CPI tracks the price of a weighted basket of goods and services throughout the time.
The inflation rate is usually measured on a year-over-year basis, which means that the current inflation rate is a percent change between the CPI today compared to the CPI a year ago. Even though the inflation rate is calculated using the CPI index, the idea of the inflation rate can be extended to any changes in price over time.
For example, if a gallon of gasoline today costs $4 while a year ago it was only $2.5, then the inflation rate for gasoline year-over-year is 60%. This inflation rate is very high although it is calculated using only one specific good.
In the example above, we can see that gasoline has become much more expensive within just one year, but a person who does not own a car may not feel the difference because they simply do not have to spend their money on gasoline.
This shows that the inflation rate can be tricky to interpret because every single person spends their money differently, so the basket of goods and services that every person purchases may deviate from the CPI composition. This deviation is very important because it means that the stated inflation rate may not be accurate for many people simply because the products used in the CPI do not represent the products people buy.
The current inflation rate in the US is reported to be 7.9%, which is considered a very high inflation rate since the Federal Reserve has a target to maintain an average annual inflation rate of 2%. Calculating the inflation rate is tricky and interpreting it is even more difficult because it is very easy to draw misleading conclusions without understanding the underlying index.
Before trying to understand how the inflation rate affects you, it is important to understand what CPI includes.
What Is CPI Composed Of?
U.S. Bureau of Labor Statistics (BLS) tracks Consumer Price Index (CPI). There are multiple CPI measures, and they are all tracked by the BLS, but the inflation rate is calculated based on only one measure, which is the CPI for All Urban Consumers (CPI-U). To understand what the reported inflation rate implies, we need to understand what is in the CPI-U metric.
CPI-U is an index that tracks a weighted basket of goods and services that is said to cover approximately 93% of the total population. CPI-U represents a weighted average price index of all goods and services consumed by urban households. Municipal service fees, such as water and sewer fees, and excise taxes are included in the calculation.
On the other hand, financial and investment products and income taxes are not included in the calculation. Even though CPI-U includes hundreds of unique items, the basket can be broken down into 6 distinct categories. The following list provides the category names, the relative weight it has on the CPI, and the description of the category.
• Food at Home – 8.193%
Food at home is a category that tracks the prices of food subcategories such as meats, dairy products, bakery products, fruits and vegetables, non-alcoholic beverages, and miscellaneous food items. The three highest weighted categories are other food items, meats, and fruits and vegetables respectively. These three categories account for 66% of the total food at home consumer basket.
• Food Away From Home – 5.195%
Food Away From Home is another food category that has a lower weight than the Food at Home category. It tracks the price of eating out. Unlike the previous category, Food Away From Home does not have a clear weight distribution by subcategories.
This means that the weight allocated to this category may deviate dramatically for different people because one person may prefer spending more money eating in expensive restaurants while the other may buy occasional fast-food meals.
• Energy Commodities – 3.995%
This category tracks the prices of energy sources that are consumed directly by the consumer. These energy sources include fuel oil, gasoline, and diesel. Energy commodities refer to any energy sources that are derived from crude oil although it is important to note that if these fuels are used by an energy provider to power your house, they are not counted towards the Energy Commodities category. Instead, these instances are calculated within the Energy Services category.
• Commodities Less Food and Energy – 21.804%
All other commodities used directly by a consumer are listed in this category. Such high weight for this category is justified because of the large number of commodities tracked by this category. For example, Commodities Less Food and Energy include subcategories such as apparel, new and used vehicles, medical care products, alcoholic beverages, and tobacco products.
New and used vehicles have the highest weight of 38% within the category because they tend to take up a large chunk of a household income when purchased. Even though this category may represent an average consumer spending quite accurately, people who do not have a car and who do not smoke nor drink may not feel the effect of inflation of these products as much.
• Energy Services – 3.418%
Energy Services encompass energy prices set by utility companies. These services are usually used to power a house or any other property or item that requires a stable energy supply. This category puts a higher weight on electricity cost, which takes up 74% of the total weight within the category.
Even though it may be true for some newer households, especially in warmer areas, many houses use gas during the winter months. Depending on the climate, the gas supply may take up a larger portion of the energy consumed by a household.
• Services Less Energy – 57.395%
This category tracks all the other services used that do not relate to the energy services mentioned above. It contains a large number of items that are broken down into 3 subcategories that are also broken down further. The 3 main subcategories are shelter, medical care services, and transportation services. Shelter tracks the rental and housing prices that usually take up the largest portion of income for many households.
Because it is such a large cost, the CPI allocates 32.802% on shelter costs alone. As a rule of thumb, an individual should spend around 30% on their rent or mortgage payments, but this cost may take up to 50% of an individual’s income in expensive areas such as New York or San Francisco.
The Medical Care Services category tracks the costs of visiting a hospital for various reasons. It accounts for about 7% of the total weight, which may be true for the average individual, but this metric may have a very high variance with some people being generally healthy and covered by insurance.
Lastly, the Transportation Services subcategory assumes that an average person spends around 6% of their income on transportation, which is not true for many individuals and largely depends on the total income and demographic.
Does CPI Represent You?
The reported inflation rate is calculated based on the categories and weights listed above. Even though it may give a general idea of how the inflation rate affects an average consumer, when it comes to a single person, there is a high chance that there will be deviations in how a single person spends their money.
Because of this, likely, the inflation rate you are taking as given may not affect you exactly how you expect. If you drive a car and pay your utility bills, the inflation rate that affects you may be much higher than what is reported simply because the price of used vehicles increased by more than 40%, fuel prices increased by 38%, and gas charges increased by 23.8% over the past year.
Of course, it is impossible to calculate the inflation rate for every single person, so it is up to you to understand how inflation of single items affects you personally.