Consumer price index (CPI) refers to a scale that analyses the weighted average of prices of a basket of goods and services as used by consumers such as food, medical care and transportation. It measures the average change over time as urban consumers pay for goods and services. The consumer price index is one of the best known lagging indicators and can express the existing prices of a basket of goods and services in terms of previous year prices for the same period, and show how inflation affects purchasing power.
Consumer price index in the UK is also known as the Harmonised Index of Consumer Prices (HICP), and is the official measure of inflation of consumer prices. The new labour government in May 1997 handed over control on interest rates to the Bank of England Monetary Policy Committee, with the responsibility of adjusting the interest rates to meet the Chancellor-approved inflation target (2.5% RPIX). In a month where the inflation falls short of the target, the bank governor is required to explain the causes in an open letter to the chancellor and take steps to restore it to normal. The United Kingdom has tracked a consumer price index figure since 1996 until December 2003 where the inflation target was revised and changed from RPIX of 2.5% to CPI of 2%.
Consumer Price Index represents all of the goods and services bought for consumption by urban consumers. These goods and services fall under 8 major groups:
The CPI also includes taxes (sales and excise) directly associated with the cost of certain goods and services. Taxes are also excluded from the CPI however, such as income tax and social security tax which are not directly connected with the purchase of consumer goods and services. In addition, items which do not relate to day to day consumption expenses such as stocks, bonds, life insurance, real estate and other investment items are not included in consumer price index as they are related to savings.
Consumer Price Index can increase or decrease over time. Consumer price data is needed to calculate the CPI. The base period price of the basket is usually marked at 100. CPI value hovers higher or lower than 100 to show that the average price has either gone up or down over the period. When the CPI value for current and base periods are available, the inflation rate over the periods can be determined.
To estimate consumer price index, surveys have to be carried out to identify the most regularly purchased items by consumers. The basket of commonly used products and services can therefore be determined. The overall price of the basket is calculated from the market for both the current and base periods.
The formula for calculating consumer price index is as follows:
| Consumer Price Index = | Current Period Price of the Basket | × 100 |
| Base Period Price of the Basket |
For a more practical calculation, adjustments need to be made to CPI in order to accommodate seasonality, changes in the composition of the basket and so on. Also, different versions of consumer price index are calculated to allow room for real life needs.
Despite the CPI being the best measure for inflation as experienced by consumers in their everyday expenses, it may not be applicable to all population groups. In addition, the CPI does not provide official estimates for the inflation rate experienced by certain subgroups of the population like the poor and the elderly.
Since CPI measures price changes based on item samples, the resulting indexes are notably different from the results that would be provided from actual records taken of retail purchases. The sampling errors or errors in estimation however do not mean mistakes in the CPI however, and should be taken as limitations on the CPI accuracy.
Apart from sampling errors, non-sampling errors also exist, occurring from a variety of sources. They are caused by difficulties in defining basic concepts and how they are implemented, and price data collection problems.
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