Inflation, the continuous increase in the general price level, has been an economic reality for many years, but the rate of increase is not constant. Depending on the phase of the business cycle, the rate may speed up or slow as consumers adjust their spending habits. One of the most important measures of inflation is the Consumer Price Index.
The Components of the CPI
The Consumer Price Index is compiled by the Bureau of Labor Statistics. Calculated monthly and annually, the CPI is based on a hypothetical “market basket” of the goods and services that a typical consumer purchases. In order to represent an average budget, the cost of each item is weighted to reflect how much consumers spend on it. Housing expenses represent approximately 41.4 percent, transportation 16.4 percent, food and beverages 14.9 percent and medical expenses 7.5 percent. The BLS adjusts the market basket periodically to reflect changes in consumer buying behavior.
The Nature of Price Changes
Prices of individual items in the CPI rise and fall with the forces of supply and demand. When supply is plentiful -- as with fruits and vegetables in the summertime, for example -- prices fall. Off season, prices rise and even soar if a frost hits an early or late crop. Likewise, the demand for products influences their prices. Rising demand will edge prices higher. BLS statisticians track these prices, select a base year for the index and measure price changes of the items in the market basket from that benchmark year. If the CPI is 100 in the base year and 103 in the second, the annual inflation rate is 3 percent.
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Price Changes and the Business Cycle
When the economy is growing in its expansionary phase, people are confident of their income and spend accordingly. Strong demand pushes prices higher. The Federal Reserve expands the money supply to accommodate growth, and more money in circulation stimulates spending and rising prices. When the Federal Reserve decides the economy is overheating, it raises interest rates, making it more expensive to purchase items on credit. Reductions in spending cause the economy to contract, bringing on a recession, which occurs when the gross domestic product shrinks for at least two consecutive quarters.
Recession and the CPI
The onset of a recession occurs when consumers curtail their spending -- especially on consumer durables such as major appliances and automobiles. (Construction -- residential and commercial -- is hard hit, too, but is not calculated in the CPI.) Consumers defer purchases, opting to repair an old car instead of purchasing a new one and postponing appliance and electronics upgrades. Consumers cut back on discretionary spending where they can. For example, they eat out less often or shift eating patterns from upscale restaurants to fast food. The reduction of demand reduces the rate of inflation. The CPI may fall during a recession. If the CPI continues to rise, it does so at a slower rate.
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