A Consumer Price Index (or CPI) is a type of index: a basket of assets whose price is tracked to gain insights into market segments. Examples of indices include the S&P 500, the NASDAQ Composite, and the DJIA (all of which measure the performance of the major stocks).

There’s no single CPI – the term refers to any type of index designed to track the prices of consumer goods, services, and household products. Suppose that we have a basket made up of the following expenses: groceries, hygiene products, travel costs, rent, etc. Basically, we can do this with anything you’d expect the average consumer to spend on. 

We’ll note down the total cost of the items in that basket, typically using weighted averages to give more “weight” to more important items. Then we’ll note the year/month/period, too. By doing this at set intervals, we can get an idea of how the index is performing over time.

Why is CPI used?

A Consumer Price Index is a powerful benchmark for measuring developments in the economy. Specifically, it’s used to monitor the impact of inflation or deflation. This is useful for many reasons – governments can gain insights into their monetary policy decisions and calculate how much should be given to those with subsidized incomes. 

Calculating CPI

Let’s say that we’ve observed the following:

We could plot these values on a chart to see how the value of the basket changes year-by-year. What we see here is a steady increase. That allows us to estimate that the costs of various goods and services in the basket are rising due to inflation.

First, we want to calculate CPI per year.  We take a base year (the one we’ll be using to compare with everything else) – let’s use 2014. Then, for every row in the table, we’ll perform the following calculation:

CPI = current year / base year * 100

Here’s our updated table:

Now, we can calculate inflation or deflation with the following formula:

(CPI in year two - CPI in year one) / CPI in year one * 100

For instance, we could say that inflation has risen by ~2.72% from 2018 to 2019, or by ~7% from 2014 to 2016. In the case of deflation, we’d expect a negative number.