How the Consumer Price Index works
By Laura Bruce • Bankrate.com

The Consumer Price Index gets a bad rap. The CPI tracks the prices of a wide assortment of products and services consumers buy, so Americans believe that by monitoring these prices they should be able to tell how big of a role inflation is playing in the economy and in their own financial lives.

But often when inflation is tame by government standards, it's causing financial hardship for many individuals, who argue that the CPI doesn't reflect what's happening in their lives.

By looking at how the CPI is put together, you may be able to see why it can seem so out of sync with your financial situation.

Every month, 400 "economic assistants" get busy making phone calls and visiting individuals, stores, supermarkets, restaurants, car repair shops, apartment complexes, hospitals and doctor's offices. They collect the prices on 80,000 items and services, says Patrick Jackman, an economist with the Bureau of Labor Statistics, the federal agency that compiles and publishes the CPI data every month.

They gather prices for eight major groups and more than 200 categories within those groups. Here are the eight groups and some of the categories.

Food and beverages -- breakfast cereal, milk, coffee, chicken, wine, snacks and full-service meals

Housing -- rent of primary residence, owner's equivalent of rent, fuel oil and bedroom furniture

Apparel -- men's shirts and sweaters, women's dresses, jewelry

Transportation -- new vehicles, airline fares, gasoline, motor vehicle insurance

Medical care -- prescription drugs, medical supplies, physicians' services, eyeglasses, hospital services

Recreation -- televisions, cable TV, pets and pet products, sports equipment, entertainment ticket admission prices

Education and communication -- college tuition, postage, telephone services, computer software

Other goods and services -- tobacco and smoking products, haircuts, funeral expenses

The CPI simply measures the change in how much is paid for these thousands of goods and services. If prices are rising it's inflation; if they're falling it's deflation.

"But there is a problem relating that to any individual household since it's the average of all households," says Jackman. "Some are renters, some are buyers and there are different consumption situations."

For instance, if you own your home and are making a fixed monthly mortgage payment, rising rents don't affect you.

You might keep your food budget down by eating more chicken or pork when beef prices increase. But since the CPI measures the same "basket" of items month after month, it doesn't do a good job of reflecting that type of substitution that shoppers do on a regular basis.

The CPI figure that is most widely quoted is based on urban consumers, so if you live in a rural area it's quite possible your costs will be different. But Jackman says there can be wide differences even between urban areas simply because of their locations.

"The 80,000 prices are fairly representative, but in some areas prices are markedly higher than in other areas. Gas prices in Washington, D.C. may be average for regular gas -- about $1.75 a gallon. But go west to Las Vegas or Los Angeles, and it may cost you $2.20."

Speaking of gas, why does the Bureau of Labor Statistics issue two inflation rates -- one with food and gas included and the other so-called "core" inflation rate, which eliminates food and gas prices? After all, does a week go by where you don't buy food or gas?

Food and energy costs can fluctuate widely from month to month and the CPI is looking for inflationary trends -- sustained increases in prices. But since you probably can't eliminate food and gas prices from your budget, you should pay attention to the overall CPI number, not the core rate of inflation.

"There are three pricing periods every month. You don't want to collect all your food prices in the beginning of the month," says Jackman. "You want a sample that's representative of the U.S. as a whole. The food and energy items are collected on a monthly basis, but most items, such as apparel, are collected bimonthly, except in the three largest metropolitan areas -- New York, Los Angeles and Chicago -- where everything is priced on a monthly basis."

As you might imagine, it takes some time to process all the information. Nevertheless, there's a pretty quick turnaround. Data collected in April, for example, is released to the public in mid-May.

Tracking prices throughout the United States is a daunting task and no one is more aware of the criticism of the CPI than the folks at the Bureau of Labor Statistics, including Jackman.

"I think we're in the middle of things. You have individual households and most people are relatively myopic (on this subject.) They end up remembering those prices that were low before and are high now and not remembering the ones that were high and have steadied or declined or risen slowly. They say their particular experience isn't being reflected by the CPI; the prices they are facing are much higher. Well, in some cases they might be, but they're not tracking them over a long period of time."