Understanding the consumer price index

The consumer price index (CPI) tracks how much the average Canadian household spends, and how that changes over time. At the Bank of Canada, we use it to target inflation.

A virtual shopping basket

There’s no way to track how every person in Canada spends money, but we can get a sense of the average household’s buying patterns. To do this, Statistics Canada fills a virtual shopping basket with about 700 goods and services that Canadians typically buy. Every month, it adds up the total cost and tracks the month-to-month change in prices.

While not a perfect measure, the CPI captures the average shopping experience of Canadians. The basket includes:

• food—groceries and restaurant meals
• shelter—rent and mortgage costs, insurance, repairs and maintenance, taxes, utilities
• transportation—vehicles, gasoline, car insurance, repairs and maintenance, public transit costs
• household expenses—phones, internet, child care, cleaning supplies
• furniture and appliances
• apparel—clothing, footwear, jewellery, dry cleaning
• medical and personal care—prescriptions, dental care, eye care, haircuts, toiletries
• sports, travel, education and leisure
• alcohol, tobacco and recreational cannabis

Each item in the basket is given a “weight,” which depends on how much a typical household spends on that item. For example, Canadians usually spend more on groceries and rent than on haircuts. So, food and shelter receive larger weights than personal care services. An increase in the price for items with a greater weight has a larger effect on the average household’s cost of living.

Why we monitor the CPI

The CPI is a simple and familiar measure of price changes, or inflation. Employers use it to make cost-of-living adjustments in wages and salaries. Governments use it to adjust income taxes and social benefits such as the Canada Pension Plan and Old Age Security.

At the Bank of Canada, the best contribution we can make to Canadians’ well-being is keeping inflation (as measured by the total CPI) low and stable. Since the early 1990s, low and stable has meant 2 percent per year.

How the CPI measures inflation

The percentage change in the CPI is a measure of inflation.

• The 12-month percentage change compares prices from one month with those from the same month the year before—for example, March 2020 compared with March 2019.
• The annual average is the average of all the months in a calendar year, from January to December.

Statistics Canada measures prices against a base year. The basket in this base year is given the value of $100. A basket of goods and services that cost $100 in the base year 2002 would cost about $140 in 2020. The extra $40 reflects inflation.

Issues with the CPI

The CPI is the most widely used indicator of price change, but it’s not perfect. The evolution of the things that we buy and the way we buy them makes measuring changes in prices a challenge. Because of this, it is difficult for the CPI to give a completely accurate picture of inflation.

As well, Canadians experience changes in the cost of living differently. The CPI may overstate how quickly the average cost of living is increasing for Canadians. Here are some reasons why:

• Substitution: People change their buying habits when prices go up or down. That means they may swap beef for chicken to save money. But the data may still reflect the cost of the “basket” with the original weights for all the goods.
• New products: Statistics Canada updates the CPI basket every two years to reflect changes to products and services and how Canadians buy them. This means it doesn’t include products that come onto the market between updates.
• Quality changes: Rapid technological advances tend to lower the cost of products like computers and electronics over time. For example, a very basic computer cost thousands of dollars in 1985. Today, one costs only a few hundred dollars and can do far more.
• Online retailers: More and more, people are shopping online where prices tend to be lower than in traditional brick-and-mortar stores. If the effect of this change is not fully captured, the CPI could be overstating the cost of living.

Base-year effects

CPI inflation is measured by comparing the price of the CPI basket today with its price (or “base”) a year ago. This means that a large movement in the prices of items in the basket causes volatility: inflation moves in one direction at first and then reverses direction a year later. This reversal is known as the base-year effect.

Let’s explore this effect further. Consider when gasoline prices dropped in March 2020 as the COVID-19 pandemic took hold:

• Over the next 12 months, the lower gasoline prices reduced CPI inflation because gasoline cost less than it had the year before.
• In March 2021, the effect of cheaper gasoline on inflation disappeared. Inflation increased because the March 2020 prices of gasoline became the new “base” levels to compare against.

During the pandemic, prices for other goods and services—such as clothing and hotel rooms—also fell sharply. That’s because either containment measures limited access to those goods and services or concerns about the virus cooled consumers’ demand. As a result:

• Over the rest of 2020, inflation was lower than it otherwise would have been.
• A year later, inflation rose because the lower prices for those items from a year ago became the new basis for comparison.