The Consumer Price Index (CPI) is a crucial measurement of the cost of living in our economy, and since the economy is always changing, the methods used to calculate the CPI are adapting to that change. In this month's blog, we will be discussing some common questions regarding CPI, such as: what it is, how it is calculated, and why it's important for actuarial analyses.
What is the CPI?
The U.S. Bureau of Labor Statistics (BLS) defines the CPI as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” It represents a weighted average of prices that reflects overall U.S. consumer spending and is used to assess inflation or deflation. The CPI is closely monitored by policymakers, financial markets, businesses, and consumers alike. Many economists also refer to it as a “cost-of-living” index.
How is it calculated?
To calculate the Consumer Price Index (CPI), the U.S. Bureau of Labor Statistics (BLS) collects pricing data from the U.S. Census Bureau, along with information from the Consumer Expenditure Survey, which helps identify where and how consumers are spending their money. The BLS organizes all goods and services into more than 200 categories, grouped under eight major areas: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. These categories are further broken down across 32 geographic regions in the United States, creating over 7,700 possible combinations of items and locations. Once all this data is gathered, the BLS aggregates it to produce a nationwide index that reflects overall price changes.
How has it changed, and what are some common concerns?
In 2023, the BLS revised its method for updating the index. The formulas used to calculate the CPI are now updated annually instead of every two years. This change affects the composition of the “market basket” and the weighting assigned to each item. The goal is to more accurately capture changes in inflation by incorporating data at a higher frequency.
Economists have raised concerns that the CPI may either understate or overstate inflation. One reason is that much of the underlying data is collected from urban areas, making the index less representative of rural regions. Another point of contention is the frequent revisions and methodological changes to the CPI. Some economists argue that the index has shifted from measuring the cost of goods to measuring the cost of living, and a few suspect that government adjustments could be aimed at producing a lower reported inflation rate. Currently, economists are worried about the impact of tariffs and if this will be reflected into the index.
Why is it important to property and casualty actuaries?
Actuaries use the CPI to estimate future losses by deriving inflation rates from historical periods. The inflation factor is calculated as:
Inflation Factor = Index(Current or Projected Period) / Index(Prior Period)
This factor enables actuaries to express past payments and wages in current-dollar terms, reflecting changes in purchasing power over time. By adjusting historical amounts for inflation, actuaries can develop more accurate, inflation-sensitive estimates of future loss experience. Actuaries take the CPI concerns into account and rely on objective data to help clients prepare for and manage potential future risks. The conversations around the index have reinforced the importance of good relationships and communication between actuaries, underwriting, finance, claims, and other functions of the risk industry.
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