Inflation sign

What Is Inflation?

What is Inflation? Inflation is the gradual increase in prices over time. Specifically, it refers to changes in the Consumer Price Index.

Understanding how price changes rise over time can help individuals budget and plan for the future. Businesses need to understand it to remain profitable. Policy makers need to know it as well to make sure that initiatives are appropriately targeted.

There is a little more complexity to it than some realize. In this article we will take a look at the basic meaning of inflation and how it is measured.

What Does it Mean?

As I mentioned above, inflation is the increase in prices over time. To put it broadly, it is a measure of the rise in the general price level, stated as a percentage.  So, when we say inflation was 2% for a period (typically a year) we are saying that the overall price level rose 2%. Think of it as an average increase in prices.

However, that doesn’t mean that ALL prices rose 2%, or even that all prices rose. It means that all of the price changes measured averaged out to a 2% increase. Some prices may have gone up by a lot. Some prices may have gone up by a little, and some prices likely even fell.

How Is Inflation Measured?

To measure inflation we need to compare two price levels at two different times to see how they changed. Most often we look at price changes over a month or year.

To do that we will compare the price level at the beginning of the period to the price level at the beginning of the next period. For example, we might compare the price level on January 1st of one year to the price level on January 1st of the next year.

But how do we know what the price level is?

Consumer Price Index

It is probably quite obvious to you that we can’t track every price of every product or service in existence with any amount of accuracy. Even if we could, the time and effort involved in doing so would not be worth it. It would also be quite expensive if for no other reason than the cost of the labor involved.

Instead of tracking the price of every single product we track the prices of a sample of products that represents what a typical household might purchase. This “basket of goods” as it is called, is the Consumer Price Index.

The Bureau of Labor Statistics collects information to construct the Consumer Price Index monthly.

The Consumer Price Index includes food and beverages, housing, apparel, transportation, medical care, recreation, education and communications, and other goods and services.

Remember, some prices in the index will rise more than others. Some prices will even fall when the overall index level rises. That’s ok, since the purpose of the index is to track the direction of the general price level.

Core Inflation

Food and energy prices are more volatile than other prices in the index. They can fluctuate quite a bit due to short-term events that don’t necessarily indicate any structural, long-term change in prices.

Droughts, seasonal diseases in food crops, and political conflict are all common reasons that food and energy prices can spike temporarily.

For that reason, it’s also useful to track the rate of inflation WITHOUT food and energy prices. To do that, we simply take these out of the Consumer Price Index. The result is core inflation.

Inflation is a key economic variable and one of the main functions of the Federal Reserve is to limit inflation. The Fed will typically adjust the money supply to affect interest rates if inflation gets too far off target. This affects prices of investments like stocks and bonds as well as home prices and the cost of borrowing.

Core inflation can help give us a better understanding of the true change in prices and help prevent us from over-reacting to short-term events.

The economy could become very sporadic and unstable if we did.

Historical Inflation Rates

The rate of inflation fluctuates over time. For the most part it has bounced somewhere between 1% and 3%. In this chart you can see historical inflation rates for both the CPI and CPI less food and energy (core inflation).

Notice how much more the standard rate fluctuates over time compared to the core rate. That really illustrates the need to track core inflation.

Consider July 2008. Inflation since July 2007 was 5.5% while core inflation was 2.5%

By January of 2009, just six months later, the overall price level had fallen enough to make inflation slightly negative for the preceding twelve months. (Negative inflation is called deflation)

When you take out food and energy prices though, the core price change was still a nearly 1.7% increase.

Inflation Rate Formula

Inflation Rate Formula

To find the rate of inflation you simply take the difference between the CPI from one point to the next (such as from June of one year to June of the next year) and divide it by the beginning level of the CPI (June in the first year). Multiply by 100 to convert the resulting decimal into a percentage.

That’s how the Bureau of Labor Statistics does it anyway. Obviously you and I can just look it up!

Causes

There are a large number of specific factors that affect inflation at any time. However, we can think of these causes in two broad terms: Demand-Pull and Cost-Push.

Demand-Pull

The price level is the result of supply and demand for goods and services. When the demand for goods and services rises faster than the supply of goods and services, the price level goes up.

This is most common at the peak of the business cycle when the economy is already producing all the goods and services it can. Even if demand increases there simply isn’t sufficient room to expand production. The result is that demand that outpaces supply and there is “too much money chasing too few goods”.

Cost-Push

If input prices increase then businesses will increase the prices of final products that include them. If they didn’t, their profits would fall. For example, if the price of beef goes up because of a widespread loss of cattle due to a disease then the price you pay for a hamburger will go up.

This increase in final prices also pushes the price level up. An increase in the average level of wages, oil, and other broad input prices can cause cost-push inflation.