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Inflation 101

What Is Inflation?

Inflation is a consistent upward movement in the overall level of prices in an economy. Prices can change for different reasons and in different ways. The price of an individual good or service can change because there is a change in its supply or demand. For example, the price of oranges can rise because of a frost in Florida, or the price of parking for sporting events can go up because of stronger demand. This rise in the price of a single good or service, however, is not inflation. Rather, inflation refers to a situation in which there is a rise in the general price level of goods and services over time. Even when the general price level is rising over time, some prices will be increasing at a faster or slower pace (or possibly even declining) compared with the pace of other price changes.

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.

Why Should You Care about Inflation?

Inflation affects everyone in the economy, and it often imposes some costs, although it can also provide some benefits. The more harmful effects of inflation stem from its unpredictability—that is, the fact that movements in inflation from period to period cannot be perfectly anticipated. However, even if we were to imagine that inflation were steady and predictable, there are still ways in which rising prices would impose costs on an economy. For example, businesses have to update materials in which their prices appear (think of a restaurant that needs to print new menus, or retailers that must print new catalogues or update price tags). At higher inflation rates, these businesses would need to expend more resources to change prices more frequently, or else their prices may be further from their desired level after accounting for the movements of competitors’ prices. Because higher inflation leads to higher interest rates, people will generally want to economize on the amount of cash that they carry in order to leave more of it in the bank where it can earn interest. Consequently, people will incur the cost of more trips to the bank. For people whose pensions or incomes are fixed in nominal terms, rising prices reduce the real purchasing power of those incomes and pensions. There are also costs associated with tax laws, which generally do not take into account the effects of inflation, especially when calculating capital gains. Even if workers receive wage increases to match inflation, higher wages can raise tax liabilities and result in their after-tax incomes’ not keeping up with higher prices.

Additional costs are introduced because inflation is not perfectly predictable:

  • Borrowers and lenders. Interest rates specified in loan agreements typically incorporate a component based on the expected rate of inflation over the length of the loan. If inflation turns out to be higher than expected, then the debtor benefits because the repayment (adjusted for inflation) turns out to be lower than what the two parties anticipated. If inflation turns out to be lower than expected, then the creditor benefits because the inflation-adjusted repayment will be higher than what was anticipated by both parties. Consequently, unanticipated inflation transfers wealth across borrowers and lenders arbitrarily.
  • Savings and investment decisions. When inflation becomes less predictable, then both consumers and firms will face greater uncertainty. Because the decisions of consumers and firms depend on their view of future conditions, greater uncertainty can cause them to alter their plans. For example, higher uncertainty about future inflation will also extend to greater uncertainty about interest rates, wages, taxes, and profits. In response, businesses may delay or postpone hiring decisions and expenditures on new buildings and equipment, while households may cut back on consumption and save more. Both of these types of responses can lead to reduced spending and lower activity in an economy.
  • Relative price changes. When the price of an item increases, it is important to know how the size of that price change compares to the sizes of other price changes. For example, when the price of an item increases more than the prices of other items, its relative price increases, and consumers will substitute toward relatively cheaper items. If the price change matches those of other items, then the item’s relative price has not changed and would not induce a substitution. The more unpredictable inflation is, the harder it is for consumers to determine the relative price change of items and the harder it becomes for them to spend their income efficiently.
  • The inflation outlook. When inflation becomes less predictable, consumers and businesses spend more time, attention, and income trying to monitor and forecast inflation, as well as making plans and taking actions to protect themselves from its effects.

What Does the Federal Reserve Have to Do with Inflation?

Central banks, like the Federal Reserve, are established to foster economic prosperity and social welfare. As with central banks in many other countries, the Federal Reserve has been given more specific objectives by the government, including those related to inflation, to meet these goals.

What is the Federal Reserve’s “dual mandate”?

The Federal Reserve is specifically charged by Congress with objectives that were originally established in the Federal Reserve Act of 1913. These objectives were clarified in 1977 by an amendment to the Federal Reserve Act that charged the Federal Reserve “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The goals of maximum employment and stable prices are often called the “dual mandate.”

Does the Federal Reserve have a specific target for inflation?

In January 2012, the Federal Open Market Committee (FOMC)—the Federal Reserve’s body that sets national monetary policy—first published its “Statement on Longer-Run Goals and Monetary Policy Strategy.” In the statement, the FOMC announced that it believed that “inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.” Thus, the FOMC’s 2 percent PCE inflation objective was born. A number of central banks from all over the world have inflation objectives, and many of them also target an inflation rate of about 2 percent. Inflation rates around these levels are often associated with good economic performance: a higher inflation rate could prevent the public from making accurate longer-term economic and financial decisions and may entail a variety of costs as described above, while a lower rate might make it harder to prevent the economy from falling into deflation should economic conditions become weak.

The FOMC has reaffirmed the statement each January since then. The publication of a statement on longer-run goals is part of the FOMC’s emphasis on clear communication and transparency.

Why doesn’t the Federal Reserve set an inflation target of 0 percent?

Even though inflation entails a variety of costs for society, most central banks—including the Federal Reserve—do not aim to have zero inflation. Economists tend to focus on two benefits of having a small but positive amount of inflation in an economy. The first benefit of low, positive inflation is that it helps to buffer the economy from falling into deflation, which entails just as many problems as inflation, if not more. The second benefit of a small amount of inflation is that it may improve labor market efficiency by reducing the employers’ need to lower workers’ nominal wages when economic conditions are weak. This is what is meant by a modest level of inflation serving to “grease the wheels” of the labor market by facilitating real wage cuts.

Does the Fed focus on underlying inflation because it doesn’t care about certain price changes?

Monetary policymakers typically devote considerable time to discussing measures of underlying inflation, and that attention is sometimes interpreted as a lack of awareness or concern on their part with certain price changes, such as those of food or energy. But policymakers are concerned with all price changes, and they look at a large number of indicators when deciding on what actions to take to meet their objectives.

For policymakers of the Federal Reserve, it is important to recognize that measures of underlying inflation serve as a guide for the conduct of policy and not as an objective of policy. One of the objectives of monetary policy is 2 percent total inflation as measured by the PCE price index, and this objective includes food and energy. But when deciding what actions to take to meet this objective, policymakers need to understand which prices changes are likely to be short-lived and which are likely to persist in order to choose the appropriate policy actions. Measures of underlying inflation provide policymakers with insights into which movements in aggregate inflation are likely to be transitory and thereby help them to undertake the actions best suited to achieve desired outcomes.

Key Inflation Concepts

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.

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.

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.