When prices rise in various sectors of the economy, you’ll start hearing analysts talk about inflation. Inflation is the devaluation of currency over timethat is, as goods and services become more expensive, the purchasing power of your money decreases.
Often, people will become aware of inflation when they notice that something they buy regularly is more expensive than usual; maybe the receipt from the grocery store or gas station is higher than expected. But not all prices rise at the same rate, i some consumers may find they don’t spend more than they did a year ago.
This begs the question: how is inflation measured? Although it seems like a simple question, calculating inflation is complicated. The economy is vast and complex; not everyone is interested in the same goods and services.
To understand how inflation is measured, we need to understand the consumer price index.
key points
- Inflation refers to an overall increase in the price of goods and services within the economy.
- Changes in a price index, such as the CPI, measure inflation.
- Other price indexes, such as PCE and core inflation, help address some of the shortcomings of relying solely on the CPI.
What is inflation?
Inflation is a reflection of the overall change in prices throughout the economy. It refers to inflation a general increase in priceswhile deflation is a general decrease in prices.
Do not confuse these terms with stagflation, which refers to a specific scenario in which both inflation and unemployment are high. Stagflation is tricky for the Fed because raising interest rates to fight inflation can lead to more unemployment.
Analysts calculate inflation by looking at price changes in a basket of goods and services. This basket usually contains a large number of items that most Americans buy in their daily lives, such as gas, groceries, and medical supplies. Data collectors record the prices of these items each month to determine whether they have fallen or risen overall.
Inflation reports are usually released every month. Inflation figures can be volatile from month to month, especially if you focus on an individual good or service. So these reports also show 12-month changes to give a more complete picture of overall price trends.
Inflation measures
While the US Consumer Price Index (CPI) is the most well-known measure inflation, several other measures attempt to capture price changes. Each of these measures can be useful for different consumers and businesses.
Consumer price index
The Bureau of Labor Statistics (BLS) is responsible for the CPI. The CPI captures the change in prices consumers pay for goods and services over time.
The CPI figure most consumers hear in the news reflects the entire basket of goods and services. However, indexes are also available by geographic area and for specific verticals of goods and services.
The CPI weights each item in its basket according to how much the average American spends on that item. In other words, goods and services that make up a lower percentage of Americans’ spending have a smaller impact on the CPI. The BLS uses the Consumer Expenditure Surveys (CE) program to review the importance of each item within the basket of goods and services.
Items enter the CPI sample through a process called initiation. A CPI data collector goes to a store and selects an item from a pre-selected category. For example, they may choose a cereal box that comes in two sizes. Data should be collected on how many people buy each size to determine their likelihood of purchase. The data collector will then randomly choose one of the sizes and track its price each month.
Naturally, items leave the CPI basket every four years. The BLS records the prices of approximately 80,000 items each month, divided into eight groups, including:
- Food and drinks
- housing
- clothing
- Transportation
- Medical care
- recreation
- Education and communication
- Other goods and services
Price index of personal consumption expenses
Another popular measure of inflation is the Personal Consumption Expenditure (PCE) price index. Although not as well-known as the CPI, the core PCE price index (that is, it excludes food and energy) is important because the Federal Reserve uses it when setting monetary policy. The Office of Economic Analysis develops this measure.
Like the CPI, the PCE price index comprises a basket of goods and services, but the relative weights of the different categories are very different in some cases. Here are some of the critical differences.
The 2022 CPI reports gave housing a “relative importance” (the percentage of money consumers spend on this category) of about 34%. By comparison, the PCE weighed shelter during the same period at around 16%. Similarly, in 2015, the BEA reported weighting the importance of medical costs at 22%, while the CPI gave it a relative importance of 8.4%.
According to the Brookings Institute, one reason for the difference in the weighting of medical costs is that the PCE price index includes all consumer items. For health care, PCE captures costs such as premiums and deductibles, in addition to expenses covered by employer-sponsored health insurance and Medicare. The CPI, on the other hand, only captures direct costs for consumers.
The result of these different weights is that they affect your indexes differently. For example, changes in healthcare costs will significantly affect the PCE, while changes in house prices will affect the CPI more.
Many articles argue whether CPI or PCE is the better index. PCE has a reputation for being less volatile than CPI. But others prefer the CPI because they believe it better represents the impact of inflation on consumer spending.
Core inflation
Core inflation can be based on any number of indices, such as CPI or PCE. It then omits certain items each month, such as gas and food prices; these items can be volatile and are only sometimes representative of global price trends.
As expected, removing the more volatile elements of the inflation measure presents a more consistent picture of inflation. However, underlying inflation may still be skewed in some cases.
To help understand why, we can compare the core CPI with the Cleveland Fed’s trimmed average CPI. While the core CPI excludes the same items each time it is measured, the trimmed average CPI removes the goods and services that are most volatile in a given month.
One can surmise why the trimmed average CPI approach would lead to more predictable results. For example, one-off events such as natural disasters could cause a sudden and unexpected increase in the price of normally stable items. Adjusting for these events each month means that the trimmed average CPI will be more representative of overall price trends.
Why are there so many ways to measure inflation?
When we hear news about inflation numbers, we usually hear BLS CPI data. But, as should be clear to you by now, the CPI is not perfect. In reality, no measure of inflation is entirely accurate, and focusing only on the CPI doesn’t tell the whole story.
At the same time, different people will care more about price changes in different parts of the economy. For example, railroad companies will be less concerned about the price of a gallon of milk and more concerned about the cost of diesel.
Similarly, consumers living in Chicago will be more concerned about their city’s inflation numbers than about inflation in Los Angeles. These nuances mean that multiple indices are needed to paint a complete picture of inflation.
CPI limitations
The consumer price index is limited by what it can tell us and its accuracy. When you look at the CPI, remember that it doesn’t tell you the actual prices of items across the country. You won’t be able to look at the report and determine whether eggs are cheaper in Montana or Oklahoma, just where the price of eggs rose the fastest.
The CPI is also not applicable to all population groups. The IPC-U, for example, records the prices of items sold in urban populations. The older people buy different things than teenagersso an increase in the general inflation rate may not reflect an increase in the price of the items you are buying.
The CPI should not be used to determine the cost of living across the country. The BLS calls the CPI a “conditional measure of the cost of living” because it does not reflect the costs borne by various social and environmental factors (including taxes).
There will always be sampling errors and non-sampling errors related to data collection. Consider looking at more than one index to understand overall price trends in the US
final words
Inflation represents a general increase in the prices of goods and services in an economy. Analysts measure inflation by looking at price fluctuations within an index. The most well-known price index is the CPI, which the BLS publishes as a monthly report. There are other measures of inflation, such as the PCE price index and core inflation. These measures help solve problems with the CPI. For example, they sometimes remove highly volatile items or weigh objects prone to movement differently.
Measuring inflation is a complicated task, which means that a single measure of inflation may be biased or may not represent certain regions or industries. Having multiple measures of inflation helps paint a complete picture and addresses the nuances of a complex national economy.
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