When prices surge across various sectors of the economy, you’ll start hearing analysts talk about inflation. Inflation is the devaluation of currency over time, meaning as goods and services become more expensive, the buying power of your money decreases.

People will often first notice inflation by realizing that something they buy regularly is more expensive than usual—maybe your grocery store or gas pump receipt is higher than expected. But not all prices rise at the same rate, and some consumers may find they aren’t spending any more than they were a year ago.

This begs the question: how is inflation measured? While it seems like a straightforward 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 must closely understand the consumer price index.

Key takeaways

  • 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 indices, such as the PCE and core inflation, help address some of the shortfalls of relying solely on the CPI.

What is Inflation?

Inflation is a reflection of the overall change in prices throughout the economy. Inflation refers to a general price increase, while deflation is a general price decrease.

Don’t mix these terms up with stagflation, which refers to a specific scenario in which both inflation and unemployment are high. Stagflation is tricky for the Fed since raising interest rates to combat inflation may lead to further unemployment.

Analysts calculate inflation by observing the 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 every month to determine whether they have fallen or risen overall.

Typically, inflation reports are released each month. Inflation figures can be volatile from one month to the next, particularly if you hone in on an individual good or service. Thus, these reports show 12-month changes as well to give a more complete picture of the overall price trends.

Measures of Inflation

While the U.S. Consumer Price Index (CPI) is the most well-known measure of 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 price change 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, indices are also available by geographic area and for specific verticals of goods and services.

The CPI weighs each item in its basket according to how much the average American spends on said item. In other words, goods and services that make up a lower percentage of Americans’ spending have a more negligible impact on the CPI. The BLS uses the Consumer Expenditure Surveys (CE) program to revise each item’s importance 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 box of cereal available in two sizes. Data must be collected on how many people buy each size to determine their purchase probability. Then, the data collector will randomly choose one of the sizes and track its price every month.

Items naturally rotate out of the CPI basket every four years. The BLS records the prices of roughly 80,000 items each month, divided between eight groups, including:

  • Food and beverages
  • Housing
  • Apparel
  • Transportation
  • Medical Care
  • Recreation
  • Education and communication
  • Other goods and services

Personal Consumption Expenditures Price Index

Another popular inflation measure is the Personal Consumption Expenditures (PCE) price index. While not as widely known as the CPI, the core PCE (meaning it excludes food and energy) price index is important because the Federal Reserve uses it when setting monetary policy. The Bureau 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 different categories are very different in some cases. Here are some of the critical differences.

CPI reports from 2022 gave shelter a “relative importance” (the percentage of money dedicated by consumers to this category) of roughly 34%. In comparison, the PCE weighed shelter during the same period at around 16%. Similarly, in 2015, the BEA reported that it weighed 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 weights for medical costs is that the PCE price index includes all consumption items. For healthcare, the PCE captures costs like 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 to consumers.

The result of these different weights is that they affect their indices differently. For instance, changes in healthcare costs will significantly impact the PCE, while changes in housing prices will affect the CPI more.

Plenty of articles argue whether CPI or PCE is the better index. The PCE has a reputation for being less volatile than the CPI. But others prefer the CPI as they think it better represents inflation’s impact on consumer spending.

Core Inflation

Core inflation can use any number of indices, such as the CPI or PCE, as its base. It then omits certain items every month, such as gasoline and food prices; these items can be volatile and are only sometimes representative of overall price trends.

As expected, removing the most volatile items from the inflation measure does present a more consistent picture of inflation. However, core inflation can still be skewed in some cases.

To help understand why, we can compare core CPI to the Cleveland Fed’s trimmed-mean CPI. While the core CPI excludes the same items every time it is measured, the trimmed-mean CPI removes whichever goods and services are the most volatile in a given month.

One can surmise why the trimmed-mean CPI’s approach would lead to more predictable results. For instance, one-off events such as natural disasters could cause a sudden and unexpected surge in the price of ordinarily stable items. Adjusting for those events every month means the trimmed-mean CPI will represent the overall price trends more.

Why are There so Many Ways to Measure Inflation?

When we hear news reports about inflation figures, we usually hear CPI data from the BLS. But as should be clear to you now, the CPI is not perfect. In reality, no measure of inflation is entirely accurate, and focusing solely on the CPI does not give us 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 about the cost of diesel fuel.

Likewise, consumers living in Chicago will be more concerned about inflation numbers for their city than about inflation in Los Angeles. These nuances mean multiple indices are needed to paint a complete picture of inflation.

Limitations of the CPI

The Consumer Price Index is limited in what it can tell us and its accuracy. When looking at the CPI, remember that it isn’t telling you the actual prices of items around the country. You won’t be able to look at the report and determine whether eggs are cheaper in Montana or Oklahoma, only where the price of eggs increased faster.

The CPI is also not applicable to all population groups. The CPI-U, for example, records prices for items sold in urban populations. The elderly buy different things than teenagers, so a rising overall inflation rate may not reflect a price increase for items you’re buying.

The CPI should not be used to determine living costs around the country. The BLS calls the CPI a “conditional cost-of-living measure” because it does not reflect expenses taken on through different social and environmental factors (including taxes).

There will always be sampling errors and non-sampling errors related to data collection. Consider looking through more than one index to understand general price trends in the U.S.

Final Words

Inflation represents a general increase in prices for goods and services across 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 releases as a monthly report. There are other measures of inflation, such as the PCE price index and core inflation. These measures help address issues with the CPI. For instance, they sometimes remove highly volatile items or weigh swing-prone items differently.

Measuring inflation is a complicated task, meaning a single measure of inflation can be skewed or fail to represent certain regions or industries. Having multiple measures of inflation helps paint a complete picture and addresses the nuances of a complex national economy.

The post How is Inflation Measured? Understanding the Consumer Price Index appeared first on Due.