The inflation rate is calculated by measuring the percentage change in a price index, most commonly the Consumer Price Index (CPI), over a specific period, such as a year. You find the CPI for the previous period and the current period, then use the formula: ((Current CPI – Previous CPI) / Previous CPI) x 100 to get the inflation rate as a percentage.
How the CPI is created
- Collect prices: Statistical agencies like the U.S. Bureau of Labor Statistics collect the prices of a large number of goods and services.
- Create a “basket” of goods: These items are grouped into a representative “basket” of goods and services that reflects what households typically consume.
- Calculate the basket’s value: The total cost of this basket is determined at different points in time.
- Construct the price index: The CPI is the ratio of the basket’s cost at the current time to its cost in a base period.
Calculating the Inflation Rate
- Find the CPI for two periods: Get the CPI for a starting point (Previous CPI) and the current time (Current CPI).
- Subtract the previous CPI from the current CPI .
- Divide that number by the Previous CPI .
- Multiply the result by 100: to express it as a percentage.
Formula:
Inflation Rate = ((Current CPI – Previous CPI) / Previous CPI) x 100
How do you measure inflation?
Statistical agencies start by collecting the prices of a very large number of goods and services. In the case of households, they create a “basket” of goods and services that reflects the items consumed by households. The basket does not contain every good or service, but the basket is meant to be a good representation of both the types of items and the quantities of items households typically consume.
Agencies use the basket to construct a price index. First, they determine the current value of the basket by calculating how much the basket would cost at today’s prices (multiplying each item’s quantity by its price today and summing up). Next, they determine the value of the basket by calculating how much the basket would cost in a base period (multiplying each item’s quantity by its base period price). The price index is then calculated as the ratio of the value of the basket at today’s prices to the value at the base period prices. There is an equivalent but sometimes more convenient formulation to construct a price index that assigns relative weights to the prices of items in the basket. In the case of a price index for consumers, statistical agencies derive the relative weights from consumers’ expenditure patterns using information from consumer surveys and business surveys. We provide more details on how a price index is constructed and discuss the two primary measures of consumer prices—the consumer price index (CPI) and the personal consumption expenditures (PCE) price index—in the Consumer Price Data section.
A price index does not provide a measure of inflation—it provides a measure of the general price level compared with a base year. Inflation refers to the growth rate (percentage change) of a price index. To calculate the rate of inflation, the statistical agencies compare the value of the index over some period in time to the value of the index at another time, such as month to month, which gives a monthly rate of inflation; quarter to quarter, which gives a quarterly rate; or year to year, which gives an annual rate.
In the United States, the statistical agencies that measure inflation include the Bureau of Economic Analysis (BEA) and the Bureau of Labor Statistics (BLS).
Why are there so many different price indexes and measures of inflation?
Different groups typically care about the price changes of some items more than others. For example, households are particularly interested in the prices of items they consume, such as food, utilities, and gasoline, while commercial companies are more concerned with the prices of inputs used in production, like the costs of raw materials (coal and crude oil), intermediate products (flour and steel), and machinery. Consequently, a large number of price indexes have been developed to monitor developments in different segments of an economy.
The most broad-based price index is the GDP deflator, as it tracks the level of prices related to spending on domestically produced goods and services in an economy in a given quarter. The CPI and the PCE price index focus on baskets of goods and services consumed by households. The producer price index (PPI) focuses on selling prices received by domestic producers of goods and services; it includes many prices of items that firms buy from other firms for use in the production process. There are also price indexes for specific items such as food, housing, and energy.
What is “underlying” inflation?
Some price indexes are designed to provide a general overview of the price developments in a broad segment of the economy or at different stages of the production process. Because of their comprehensive coverage, these aggregate (also called “total,” “overall,” or “headline”) price indexes are of considerable interest to policymakers, households, and firms. However, these measures by themselves do not always give the clearest picture of what the “more sustained upward movement in the overall level of prices,” or underlying inflation, happens to be. This is because aggregate measures can reflect events that are exerting only a temporary effect on prices. For example, if a hurricane devastates the Florida orange crop, orange prices will be higher for some time. But that higher price will produce only a temporary increase in an aggregate price index and measured inflation. Such limited or temporary effects are sometimes referred to as “noise” in the price data because they can obscure the price changes that are expected to persist over medium-run horizons of several years—the underlying inflation rate.
Underlying inflation is another way of referring to the inflation component that would prevail if the transitory effects or noise could be removed from the price data. From the perspective of a monetary policymaker, it is easy to understand the importance of distinguishing between temporary and more persistent (longer-lasting) movements in inflation. If a monetary policymaker viewed a rise in inflation as temporary, then she may decide there is no need to change interest rates, but if she viewed a rise in inflation as persistent, then her recommendation might be to raise interest rates in order to slow the rate of inflation. Consumers and businesses can also benefit from differentiating between temporary and more persistent movements in inflation. For these reasons, a number of alternative measures have been developed to measure underlying inflation.
How is underlying inflation measured?
One popular approach to removing noise in price data has been to exclude components that are viewed as the source of noise in aggregate price indexes such as the CPI or PCE price index. Some of these measures of underlying inflation assume the noise is related to the size of price changes (smallest and largest), while others associate the noise with particular items (with the most common example being food and energy). The median CPI is an example of the former in that all price changes are excluded from the index except the one in the middle, while core CPI and core PCE are examples of the latter, in that both exclude food and energy prices. The Consumer Price Data section talks about underlying inflation measures in more detail.
There are other measures of underlying inflation whose design does not require excluding components. Despite their varied nature, these measures share a common purpose—to provide an estimate of the persistent component of inflation.
What is the Consumer Price Index?
The Consumer Price Index (CPI), produced by the Bureau of Labor Statistics (BLS), is the most widely used measure of inflation. The primary CPI (CPI-U) is designed to measure price changes faced by urban consumers, who represent 93% of the U.S. population. It’s an average, though, and doesn’t reflect any particular consumer’s experience.
The CPI is constructed each month using 80,000 items in a fixed basket of goods and services representing what Americans buy in their everyday lives—from gasoline at the pump and apples at the grocery store to cable TV fees and doctor visits. The BLS uses a survey of American families called the Consumer Expenditures Survey to determine which items go in the basket and how much weight to assign to each item. Different prices are weighted according to how important they are to the average consumer. For instance, Americans spend more on chicken than tofu, so changes in the price of chicken have a greater impact on the CPI.
The federal government uses a version of the CPI—the CPI for Wage Earners and Clerical Workers—to adjust Social Security benefits for inflation.
How does the government get price data for the CPI?
The BLS collects price data each month by conducting two surveys: one records the prices of most goods and services, the other the price of housing. For most goods and services, BLS representatives visit (online or in person) or call various stores across the country and record what different items cost. During each trip, the data collector records the prices of the same goods and services as last month. Prices in New York, Los Angeles, and Chicago are collected every month, as are food and energy prices across the country. Prices for commodities from all other places (which tend to represent a smaller chunk of the overall basket) are updated every other month.
In the housing survey, the BLS collects the prices of 50,000 residences through personal visits or telephone calls. If a housing unit isn’t rented but is owned by the resident, they use what is called the owners’ equivalent rent: the BLS finds what it would cost the owner to rent a similar place and uses that as the price for housing instead. Since rentals do not change frequently, the rent of each unit is sampled every six months, allowing the BLS to survey more houses overall.
HOW ARE CHANGES IN THE CPI REPORTED?
The BLS reports the change in prices from one month to the next. The CPI rose 1.3% from May to June 2022, adjusted for the usual seasonal fluctuations, but didn’t change at all between June and July 2022. The CPI can be volatile from one month to the next, but the trend in the monthly change over several months can be an important indication of inflation. Another commonly used measure posted by the BLS and often reported in the press compares the CPI in one month to the same month a year earlier – in other words how much prices have risen over the past 12 months. In July 2022, for instance, the CPI stood 8.5% above the year earlier reading. This approach is less influenced by a month with a particularly small or large change but both ways of reporting changes in the CPI are accurate.
How are tax brackets adjusted for inflation?
Another version of the CPI called the Chained Consumer Price Index for All Urban Consumers has been used to adjust tax brackets for inflation instead of the primary CPI since Congress changed the law in 2017.
The primary CPI can overstate inflation because it prices the same basket of goods from one month to the next (although items are updated every two years), and it doesn’t take into account substitutions between similar goods. So, if a good (say, apples) becomes more expensive, and people choose to buy more of its substitutes (like peaches), the CPI calculates the price level as though people are still buying the same amounts of each item, just at a different price.
The chained CPI, however, takes into account the substitutions between similar items. It does this by updating its basket according to what people buy from one period to the next. Basically, the BLS calculates one measure of inflation using the basket from the first period, and another measure from the basket in the second period (which can have fewer apples and more peaches), and reports their average. This “chains” the impact of price changes across months, making the Chained CPI better at capturing consumer spending patterns and measuring the true impact of higher prices.
Because it factors in substitutions away from higher-priced items, inflation measured by the Chained CPI runs slightly lower than primary CPI. The effect can add up over time. Between 2000 and 2020, the CPI went up by 54.5%; the Chained CPI by 45.9%. Using the Chained CPI to inflation-adjust tax brackets means that tax bracket thresholds increase more slowly and Americans pay more in taxes over time than they would if the primary CPI was used.
What is the price index for Personal Consumption Expenditures (PCE)?
The price index for Personal Consumption Expenditures (the PCE price index) is another measure of inflation, this one produced by the Bureau of Economic Analysis (BEA) using data on prices from BLS. The PCE price index measures the change in prices for all consumption items, not just those paid for out-of-pocket by consumers. For example, the weight on health care in the PCE reflects what consumers pay out-of-pocket for premiums, deductibles, and copayments as well as the costs covered by employer-provided insurance, Medicare, and Medicaid. In the CPI, only the direct costs to consumers are reflected. This difference in scope means that the PCE deflator and the CPI have very different weights. For example, the weight on health care is 22% in the PCE index, but just 9% in the CPI. The weight on housing is 42% in the CPI, but just 23% in the PCE index. That means that a given increase in health care prices will affect the PCE index much more than it will affect the CPI.
The Fed uses the PCE price index as its main measure of inflation. Its long-run target for inflation is for the PCE price index to increase at an annual rate of 2% over time.
The PCE is also a chained index, while the primary CPI is not. This means that, like the chained CPI, the PCE is better at accounting for substitutions between similar items when one of them becomes more expensive. Because its formula uses updated data, the PCE is believed to be a more accurate reflection of price changes over time and across items. Over time, the two measures tend to show a similar pattern, but the PCE tends to increase between 2 and 3 tenths less than the CPI. For example, the CPI-U increased 1.7% per year, on average, from 2010 to 2020; the PCE price index increased 1.5% per year on average over this period.
What is the connection between the Phillips curve and inflation?
The Phillips curve helps to explain the link between inflation and the state of the economy. In general, the Phillips curve suggests that inflation is relatively high when the economy is strong and the unemployment rate is low, and inflation is relatively low when the economy is weak and the unemployment rate is high. However, economic conditions are only one of the factors that determine inflation. Some of the other drivers of inflation include changes in energy prices, fluctuations in exchange rates, the productivity of the workforce, and people’s expectations over where inflation is going in the future, among others. For these reasons, inflation may not always be tightly connected to economic conditions and the ups and downs of the business cycle.
The Phillips curve is named after economist A. W. Phillips, who initially identified the relationship between unemployment and wage inflation in the United Kingdom, and subsequent work extended the idea to inflation as measured by prices as well.
The Phillips Curve
The Phillips curve describes the inverse relationship between the inflation rate and the unemployment rate. When the unemployment rate rises, say from 4 percent to 7 percent (moving from point A to point B), inflation tends to fall, in this case from 5 percent to 2 percent.
What is hyperinflation?
When inflation is extremely high and typically accelerating (prices are rising rapidly and generally at an increasing pace), an economy experiences hyperinflation, which is usually associated with or can cause social upheaval and civil unrest. The best known example of hyperinflation occurred in Germany between World War I and World War II. More recent examples include Venezuela starting in 2017, Zimbabwe in the 2000s, and Yugoslavia in the 1990s. One common definition of hyperinflation is when inflation is more than 50 percent per month. In some extreme cases, hyperinflation can be so intense that prices double within a matter of days.
What is deflation?
While inflation imposes costs on a society, the opposite scenario, deflation—when the overall price level falls for a sustained period of time—can be costly, too. Deflation can change people’s behavior in ways that hurt the economy. If people think prices will go down in the future, they have less incentive to spend their income now. When prices fall, and people buy less, businesses might need to lower their employees’ wages or even lay off workers. These actions could then set in motion a “deflationary spiral” in which reluctance to spend leads to lower economic activity and a faster decline in prices, with the process then repeating itself.
Hyperinflation in Europe during the early 1900s
Prices in Germany skyrocketed during the early 1920s as the country experienced hyperinflation. Consumers needed baskets of money to purchase even small items or even burned the virtually worthless paper marks, the German currency at the time.
Is disinflation the same as deflation?
No. Disinflation refers to a slowdown in the inflation rate, as would be the case if the inflation rate moves from 6 percent to 4 percent. The overall price level is still rising, but at a slower pace than before.
What is stagflation?
While the Phillips curve posits that high inflation tends to occur alongside a strong economy and low unemployment, stagflation refers to the combination of relatively high inflation and a very weak economy. The US experienced two bouts of stagflation during the 1973–75 and 1980 recessions, when inflation (as measured by the year-over-year change in the CPI) was above 10 percent even as the unemployment rate was rapidly rising.
What is core inflation?
Core inflation, whether the CPI or the PCE price index, is defined as the change in prices excluding food and energy prices, which tend to be volatile. While food and energy are, of course, major parts of any household’s budget, core inflation is often seen as a better indicator of the underlying pace of price changes.
Other approaches to discern the underlying inflation trend include the Cleveland Fed’s trimmed-mean CPI (which excludes the CPI components that show the most extreme monthly price changes) and median CPI (which reflects only the change in price in the center of the distribution of price changes). These measures get rid of “noise” by leaving out whichever prices behave erratically each month, rather than singling out food and energy prices every time.
So, compared to the trimmed-mean of median CPI, core CPI is more susceptible to temporary swings in prices that aren’t food or energy related. For example, when the price of used cars surged during the COVID-19 pandemic, rising 29.7% in May 2021 compared to the previous year, it pushed the core CPI up 3.8%. The trimmed-mean CPI, on the other hand, rose only 2.6% in the same month, showing that most items were only moderately more expensive.
How do price indexes account for quality change?
Accounting for quality change is one of the thorniest issues in price measurement. Tracking the price of the same good over time works well when the exact same good—a dozen large eggs, for instance—is sold from one period to the next. But often that isn’t the case. For example, new versions of the iPhone are introduced to the market on a regular basis. The iPhone someone buys today is of better quality than the one bought five years ago. In addition, entirely new goods are sometimes introduced that might make people much better off.
Economists think that the benefits of those goods should also be captured in price indexes so we can distinguish between price increases that reflect better quality and those that reflect true price inflation. The BLS has made some progress over time in accounting for quality—for example, for some goods they use “hedonics” to try to adjust prices for the value of new attributes—but price indexes still likely reflect a mixture of true inflation and quality improvements. This is particularly true because the sectors of the economy in which quality is particularly hard to measure, such as health care and education, are growing as a share of the overall economy.