What is inflation and how is it measured?

What is inflation?

Inflation is an overall increase in the prices of goods or services in an economy. Over time, currency loses value and it doesn’t have as much purchasing power as it once did. In other words, whatever a dollar can buy is reduced over time. Inflation can occur for a variety of reasons, like higher wages, lower interest rates, supply chain issues, or broader issues in the global economy.

For example, assume a certain item cost $1.50 in 1920. After accounting for inflation, that same item would cost $10.50 in 1970 and $20.50 in 2021.

How is inflation measured?

There are many ways of measuring inflation, but one of the most common measures is the Consumer Price Index for Urban Consumers (CPI-U), which is produced by the Bureau of Labor Statistics. The CPI-U shows changes in the prices paid by urban consumers for a “representative basket of goods and services.” or the most common goods and services purchased on an average month based on detailed surveys of what Americans spend their money on. The urban consumer group represents about 93% of the total US population.

There are four major categories of purchases covered in the CPI-U: food, energy, commodities like cars and clothes, and services like rent and healthcare. Not all categories are considered equally when generating the overall measure of inflation — each category is assigned a “relative importance” based on its proportion of all expenditures. Services typically are given the highest relative importance, followed by commodities, food, and energy^[1].

The overall CPI, also known as “headline” CPI, is measured by the percent change in these categories from one period to another. Since food and energy categories are typically much more volatile than the other parts of the CPI, economists often focus more on a metric called the “core” CPI which excludes these two categories.

How is inflation managed?

The Federal Reserve (more commonly called, the Fed) is the central bank of the US. Among the many responsibilities the Fed has for economic and financial stability, it is tasked with a dual mandate by Congress. The Federal Reserve aims to keep long-term inflation around 2% to balance its dual mandate of maximizing employment while keeping prices stable.

The Fed manages inflation in two ways: through adjusting interest rates and quantitative easing.

Adjusting interest rates restricts or adds money into the economy, which indirectly impacts inflation. The Fed can adjust interest rates every quarter.

Quantitative easing is when the Fed trades in assets backed by the Treasury Department. The Fed has only done this during economic emergencies such as the Great Recession and the COVID-19 pandemic. The assets are owned by US banks, like bonds or other securities. When the Fed buys assets, it adds money to the economy by freeing up banks to make more loans to people or businesses. When the economy recovers and inflation rises, the Fed can then sell those assets, reducing money in the economy. The expectation is this will reduce inflation.

The Federal Reserve typically focuses on a different measure of inflation than CPI-U called the Personal Consumption Expenditures (PCE) price index. The PCE is somewhat more stable than the CPI-U. It also relies on a market basket of items, but instead focuses on what businesses are selling. Inflation as measured by the core CPI-U is typically about half a percentage point higher than the PCE.

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