What’s in Your Market Basket? Why Your Inflation Rate Might Differ from the Average

Does a dollar go as far as it used to? It might seem that you're paying higher and higher prices for the goods you buy. However, the data show that inflation has been virtually nonexistent for much of 2015. And the inflation rate has been lower than the Federal Reserve's 2 percent inflation goal for more than 3 years.¹

Nevertheless, when many people hear reports of lower-than-average inflation rates, they may not feel it reflects their experience as consumers. Where is the disconnect between the experience of individuals and what the data show?

What Is Inflation?

Generally speaking, inflation means the average level of prices is rising. More specifically, inflation is a general, sustained upward movement of prices for goods and services in an economy. Prices have tended to rise over time, which means that the inflation rate (the percentage increase in the average price level of goods over a period of time) has been positive. And, as prices rise, the purchasing power of each dollar diminishes. A 2 percent inflation rate means that (on average) a dollar buys 2 percent fewer goods and services than it did last year. You might be surprised to discover that even after accounting for the effect of rising prices (inflation), average incomes have risen over time.² So, while it's true that prices generally rise over time, so do people's incomes, which usually allows them to purchase more goods and services.

Even though you rarely find people discussing rising prices as an economic benefit, most economists believe that a low and stable rate of inflation is beneficial for the economy.³ To this end, many central banks have a mandate of price stability, which means they are directed to intentionally generate a low and steady rate of inflation. The Federal Reserve System, the central banking system of the United States, has a dual mandate of price stability and maximum employment and has interpreted price stability as a 2 percent inflation objective.⁴

How Is Inflation Measured?

Inflation can be measured in a variety of ways, depending on which "basket" of prices is measured and how those prices are weighted. The most widely reported measure of inflation is the consumer price index (CPI). The CPI measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The current CPI market basket was constructed based on input from spending diaries kept by 28,000 consumers and another 60,000 quarterly interviews conducted in 2011 and 2012. All this information was used to determine what people were actually buying.⁵

Data collectors visit places of business to collect price information monthly to record the prices of about 80,000 items that make up the market basket.⁶ The prices of goods and services in the market basket are then "indexed" to make it easier to compare changes in the price of the market basket over time. To do this, the Bureau of Labor Statistics sets the price of the market basket during a particular time period equal to "100." Changes in the index value are used to measure inflation and calculate the inflation rate. For example, if the index rises from 100 to 103 in a year, the inflation rate for that 1-year period is 3 percent. Also, notice the use of the word "urban"; the CPI is meant to reflect the purchases of the typical urban consumer, which represents about 87 percent of the U.S. population.^7,8 People who live in rural nonmetropolitan areas, farm families, people in the armed forces, and those in institutions are not included in the calculation; therefore, the CPI does not attempt to reflect price changes for these consumers.

Your Personal Inflation Rate

Statistics are often reported as an average, but that average might not reflect the experience of any given individual in the sample. For example, the average age of a person living in the United States is 37.6 years⁹ and the average income is $46,163 (personal income per capita).¹⁰ Are you 37.6 years old with an income of $46,163? Chances are you don't fit this average exactly. Similarly, your personal inflation rate will likely differ from the CPI inflation rate. The CPI market basket is an average calculated to reflect the spending of the average urban household, not any specific individual household.

Because each individual buys a different basket of goods and services, potentially every person has his or her own inflation rate. Your personal inflation rate depends on how you spend your money. For example, let's assume you hit the "average person" mark fairly closely: You are about 37.6 years old, born on January 1, 1978 (editor's note: at time of this writing). During your lifetime, the prices of all items in the CPI market basket have risen approximately 278 percent (an average annual rate of 3.7 percent). However, when separated into categories, medical care has risen 653 percent (an average annual rate of 5.6 percent), while apparel has risen only 57 percent (an average annual rate of 1.3 percent) since your birth.

You can likely see how your individual market basket influences your personal inflation rate (see the figure). If you have spent a larger portion of your income on medical care, for which the average price has risen faster than most prices, your personal inflation rate has been higher than the CPI inflation rate. On the other hand, if your twin sister has spent a larger portion of her income on clothes, for which the average price has risen more slowly than most prices, her personal inflation rate has been lower than the CPI inflation rate.

NOTE: As stated in the essay, the average age of individuals in the United States is 37.6 years. Assume here that the average person was born on January 1, 1978. Using FRED® to set the index at 100 on that date, prices of all items in the CPI market basket have risen approximately 278 percent (blue line). However, when separated into categories, medical care has risen 653 percent (red line), while apparel has risen only 57 percent over that period (green line).

SOURCE: FRED, Federal Reserve Bank of St. Louis. Consumer Price Index for All Urban Consumers: All Items, Medical Care, Apparel: https://research.stlouisfed.org/fred2/graph/?g=1AxN.