What does the CPI mean to inflation and why should you care?

One of the nerdier things that I do is that I read the CPI (Consumer Price Index) so that my students and clients don’t have to. I’ve found that there’s a whole lot of people who don’t understand what the CPI is or how it relates to our inflation rate or why they should even care.

So, if you’ll let me explain, I won’t bore you with jargon and I’ll try to explain exactly how changes in the Consumer Price Index directly impact the money that goes into, and out of, your pockets.

The Consumer Price Index or CPI for short is compiled and released every month by the Bureau of Labor Statistics (BLS), which is a sub-agency of the Department of Labor and it represents “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”

Without going into too much detail about how the info is collected, the term “market basket” means the detailed expenditure information provided by families and individuals on what they actually bought, taken from surveys and purchase diaries of about 24,000 consumers from around the country, on their spending habits, buying all manner of things from soup to vehicles and televisions to eye exams. The things that are included in the ‘market basket’ are changed/updated every five years to keep up with tech and trends. The current CPI is based on 582 items available in 2020.

That figure is called the base.

They then compare that to current prices in order to get the CPI index. For fellow numbers nerds, here is the equation.

For everyone else, what that index number tells us is what determines the reported rate of inflation.

The uncomfortable truth is that that survey info is collected every two years. For example, according to the Bureau of Labor’s own website, reading the fine print you learn that CPI data in 2020 and 2021 was based on data collected from the Consumer Expenditure Surveys for 2017 and 2018. Meaning that the info we have for 2022 is really from 2020.

Here’s the first paragraph of the June 2022 CPI data, released July 13^th.

“The Consumer Price Index for All Urban Consumers (CPI-U) increased 1.3 percent in June on a seasonally adjusted basis after rising 1.0 percent in May, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 9.1 percent before seasonal adjustment.”

If you didn’t know any better you might say, “Well those numbers in the first sentence aren’t that bad. 1.3% doesn’t sound so terrible.”

But then when you read the last sentence and understand that 1+% number is monthly and that 9.1% number represents the current annual inflation rate for 2022, if we continue to see over 1% month over month increases by the end of the year, we will easily be in double digit inflation.

Remember, the prices they’re basing this on are already dated and the BLS has changed the ‘market basket’ dramatically since the turn of the century so it’s no wonder that some conspiracy theorist economists are saying that the ‘real’ inflation rate is more like 17%.

It’s not really, so don’t panic, but it’s likely going to get worse before it gets better.

For those of you not long in the tooth enough to remember the “Misery Index” back during the Jimmy Carter years, the misery index measured the inflation rate, the unemployment rate, and the interest rate, all of which we’re in double digit territory. Trust me on this one, no one in their right mind wants a repeat of that era.

While I don’t expect interest rates to jump to double digits you should be aware that the Federal Reserve has leaked that they could hike interest rates by a full percentage point at its next meeting for the first time since the Gen Z generation began (30 years ago). In June, the Fed raised interest rates by three-quarters of a percentage point, which it hadn’t done since 1994. Apparently, their previous efforts to stop the rampant inflation isn’t working.

So, if this is really bad, what should it look like?

In terms of economic cycles, a moderate amount of inflation, about 2%, is generally considered to be a sign of a healthy economy, because as the economy grows, people have more discretionary money to spend and the demand for all manner of stuff increases. This increase in demand then pushes prices higher, little by little, as manufacturers try to supply more of whatever the things are that buyers – both consumers and businesses – want. Employees benefit too, because this economic growth drives an increase in demand for labor, and as a result, unemployment decreases and wages generally increase.

More workers getting a paycheck and workers with better wages buy more stuff, and so this “positive” trend continues. Inflation isn’t the cause, but it is a continuous by-product of an obviously healthy and growing economy.

However, should inflation suddenly spike, like it has recently. That could also lead to a slowdown in the economy, because things get too expensive to buy, which in turn, will cause less demand, less manufacturing and unemployment to increase.

For example, I’m spending about $100 more per month on gasoline than I did last year. That means that I don’t have that $100, or the difference in food costs and just about everything else, to spend elsewhere.

When my wallet closes up so does hundreds of thousands of others. 

In contrast, low inflation (less than 1%) is equally as bad, because it usually signals a slowing economy and a lower demand for goods and services can depress wages and can even lead to increases in unemployment. Low inflation also means lower interest rates. Too low interest rates discourage lending because lenders typically don’t want to lend money at rates that don’t give them a decent return. Too slow and a recession sets in.

It’s not hard to figure out that both too low and too high inflation are “negative” trends. So, the Fed tries to do a balancing act and sometimes – like now, apparently – they trip up.

Combine that with a full-on Bear market and we’re probably in for a rough rest of the year.

There you have it. Everything you need to know about the relationship of CPI and inflation in a nutshell. Think of inflation as a dragon you must slay to survive because if you do nothing, it will eat your wealth bones and all.

In my book, The Millennial Money Tree, I talk about how you should prepare for inflation in your future. You really need to consider it a sort of variable tax on everything that almost always goes up and rarely comes down. And not all commodities have the same inflation rate.

I’m sure we’ve all heard commentary from our grandparents about how much cheaper things were ‘back in the day’. In most cases that’s true. And in some cases, it seems radically true today, like gasoline, which is about 30% higher than it should be if inflation were the only culprit in its increase in price. Unfortunately, it’s not.

I’ve also heard Gen Zs and Millennials complain about the necessity of student loans to attend their college of choice because costs have increased “so dramatically” since their parents/grandparents attended college. I can attest to some truth of that matter since I know that the cost of one year of tuition at my alma mater in 1975 was $15,000 and change. In 2022 a single year’s tuition is just shy of $45,000 – a 200% increase.

According to the National Center for Education Statistics, the price to attend a four-year private college, full-time in 1980, was $10,231 annually — including tuition, fees, room and board. Today that’s $36,087 (including tuition, fees, room and board for undergraduates at private schools living on campus). That’s a 252% increase.

However, choice has a lot to do with cost. You can still get a 4-year college degree for under $40k (meaning less than $10,000/yr) in many states if you live there.

Let this sink in. When you take into consideration that the average hourly wage in 1975 was $6.50 (the minimum wage back then was $2.10) and as of Jul 12, 2022, (according to ziprecruiter.com) the average hourly pay in the United States is currently $33.77 an hour (that’s a 419% increase) is it any surprise that college costs have increased over so many years?

It shouldn’t be…to anyone, but that’s the price of financial illiteracy.

This may sound harsh but unfortunately, had their parents had a better understanding of inflation, they might have planned better, or at the very least, prepared their sons and daughters for the ‘sticker shock’ predictable increase in college tuition. While pundits and complainers blame the high costs on greedy colleges when the student loan system was taken over by the Department of Education and defaulted loans were guaranteed by the US government, the reality is that while college tuitions may have jumped since that system started, had they kept pace with inflation all along, they’d be pretty much right where they are anyway.

According to InflationData.com’s inflation calculator, which uses data directly from the CPI Index, the total inflation from January 1980 to December 2021 is 258.36%, so $10,231 after inflation for that time period is $36,663.54.

The simplest explanation of inflation is that the same amount of money will lose its value in the future so you will have to have more money years down the road to pay for the same things you might buy today. And unlike the last 40+ years, wage increases today aren’t keeping pace with inflation, so there’s that to think about as well. That may change, but it may not.

Let’s imagine you want to know what your one-year-old child might be paying for his or her college tuition. The easiest way is to take a look at historic values and calculate for what is better known as ‘future value’. For example, the dollar had an average inflation rate of 2.53% per year between 2002 and today (20 years), meaning a cumulative total price increase of 64.71%. That means that today’s prices are 1.65 times higher than average prices since 2002, according to the Bureau of Labor Statistics Consumer Price Index.

We can use the Vertex42.com Inflation Calculator to calculate future costs. So, if we plug in the current average cost of college tuition of $36,087 and we assume the inflation stays relatively the same as it has the last 20 years at 2.53% then in 2042 we find that the average cost of college tuition for one year might be $59,479.86.

Ouch! That’s more than the current average annual income in the US today.

But remember, the rate of inflation just last year, in 2021, was 7.0% annually and for May 2022, the year-to-year inflation rate was 8.6% and June was 9.1%, so 2022 is likely to be even higher than 2021, skewing that 20-year average in a direction we don’t want it to go. Just a 1% increase in that average means the price of college tuition for a single year doubles to $72,222.92 by 2042.

But is a 3.53% inflation rate over the next 20 years realistic?

Unfortunately, that’s really conservative. If you were planning for retirement you’d be using a longer timeframe to get a better idea of historic averages.

According to worlddata.com, “During the observation period from 1960 to 2021, the average [US] inflation rate was 3.8% per year. Overall, the price increase was 829.57%.” Meaning an item that cost $100 in 1960, was $929.57 in the beginning of 2022.

At that 3.8% average, let’s say 40 years from now, you better be prepared to be paying 344% more for the things you buy today.

Holy cats. So…what to do now?

What actions can you take right now to combat the negative impact that inflation has on your dreams of financial freedom in the future? Or a college education for your kids free from the burden of tremendous student loan debt before they even start their career path?

First, don’t freak out. The high inflation rates won’t be around forever. If you don’t have one already, now’s the time to create a budget and stick to it. Do the math to figure out what you’ll need down the road and start a savings and investment plan to make it your reality. You can’t hit a target you can’t see.

Find a side hustle and make some extra money. You might get lucky and turn a passion/hobby into a full-time income.

Also, Bear markets present lots of bargains and the good news is they generally don’t last a whole year, so buy strong companies while the prices are low. Particularly companies that are strong dividend providers. Those dividends over time plus the increase in value of the underlying stock can spell a double dip uptick for your portfolio (large or small) and dividends will keep coming as long as you continue to own the stock. Cash flow for doing nothing but making a smart decision.

And don’t get me started on the bargain basement prices of crypto right now. If you’re into cryptocurrencies, forget the ‘alt’ coins and buy Bitcoin or Ethereum. Everything else follows the path that those two set. One Bitcoin might pay for several college tuitions 20 years from now if it does what it has done in the last 10 years, but that’s a risk like any over investment. All crypto is far more a long-term play than traditional equities. Don’t say I didn’t warn you.

Cut corners where you can and be prepared for even higher prices down the road short-term. Inflation tends to make prices go up like rocket but once the economy starts to recover, prices tend to come down like a feather – slow –  and sideways a lot. But know that not all prices will come down.

Hopefully, I’ll have happier news to report in the future but remember, the best time to plant a money tree was 20 years ago. The second best time is right now.

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And if you haven’t done so already, get my book and learn how to plant your own money tree.

PS. Infodata.com also has a really cool Cost of Living Calculator that compares cities you might be thinking of moving to. Location can do a lot to free up money you might otherwise be spending on housing and transportation.