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"The US economy is excellent. Inflation is down and unemployment rate is at its lowest in decades!"

These are the latest news headlines. It seems that everywhere we look, we are reminded how good our economy is doing. And indeed, the economy is great but how do the economists really know that? Is there a simple way to gauge the economy?

The answer is no! There is no simple way of figuring out how the economy is doing. There are, however, many different indicators that, once put together, can give us a rather clear picture of the economy’s health. One such economic indicator is the Consumer Price Index (CPI)

The CPI, calculated by the Bureau of Labor Statistics, is called an inflation indicator. Indeed, published every month, the CPI is the most important inflation indicator in the United State. The way it is calculated is pretty simple, yet it serves a very important purpose. The Consumer Price Index is an estimation of the price changes for a typical basket of goods. In other words, the prices of everyday goods such as housing, food, education, clothing, etc., are compared from one month to the next and the difference represents the CPI. Of course the goods are weighted appropriately in order to get an accurate measure. (For example food counts more than education since it is one of the main daily spending.) The index is calculated in relation to a base period set from 1982 to 1984 where it was set to 100 (In August 1999 the CPI was 167.1). If this number rises excessively, it means that the cost of living is rising and therefore we have inflation, which in turn causes the Federal Reserve to take appropriate measures to control it.

Having said that, it is important not to get too attached to the monthly changes in the CPI. Rather, one must look at the changes over a long period such as a few months or a year. This is important because seasonal price changes tend to cause temporary fluctuation in the price of goods without necessarily creating inflation! As much as the Index tries to adjust for those changes it is better to look at the CPI over a long period of time such as one year to get the most accurate inflation reading.

The CPI is used by the federal reserve when deciding the changes that need to be made to the interest rates as well as by investors when trying to predict the future price of securities. Indeed, when inflation is rising, it causes people to buy less goods, therefore reducing the profits of companies (such as Kmart, Ford, etc.). This loss of profit in turns causes the company's stock prices to drop as well.

This shows how important it is to monitor the Consumer Price Index whether you are an individual investor, a member of the federal Reserve Board or simply someone who is trying to estimate future costs and spending.