Using Price Indexes to Measure the Inflation Rate

By Kristie Engemann, Public Affairs Staff

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Inflation is a general, sustained upward movement of prices for goods and services in an economy. In other words, inflation refers to upward movement in prices overall during a period of time—not simply the price of a single good.

In a given month, some individual prices may increase a lot, some may increase a little, some may decrease, etc. Furthermore, some prices fluctuate more than others from month to month.

So, how do we know what prices are doing overall?

Price Indexes Take the Pulse of Many Goods and Services

The inflation rate can be estimated using a price index, which gives a sense of how overall prices in the economy are evolving. A common calculation is the percentage change from a year ago. If a price index is 2 percent higher than a year ago, for instance, that would indicate an inflation rate of 2 percent.

In addition to inflation, you may have heard terms like “disinflation” and “deflation.” Price indexes can provide insight into these trends, as well.

• Deflation is the opposite of inflation. It’s a general, sustained downward movement of prices for goods and services. If a price index is, say, 2 percent lower than a year ago, that would indicate a negative rate of inflation (-2 percent), aka deflation.
• Disinflation is a decrease in the inflation rate, or a slowdown in the upward movement of prices. For instance, disinflation would occur if the inflation rate was 2 percent during one period but 1 percent the next. In other words, the inflation rate declined but remained positive.

Two Indexes of Consumer Prices

Economists look at many price indexes to keep an eye on inflation trends—including those specific to consumers, producers, imports/exports, housing and so on. However, this post focuses on price indexes from a consumer’s perspective. Think various prices you pay that are associated with cars, food, clothing, housing, etc.

Two common indexes of consumer prices are:

• The consumer price index, or CPI. Put out by the Bureau of Labor Statistics, this measures the average change over time in the prices that urban consumers pay for a market basket of goods and services.
• The price index for personal consumption expenditures, or PCE. Prepared by the Bureau of Economic Analysis, this index accounts for prices that U.S. consumers pay for a wide range of goods and services. It also accounts for changes in consumer behavior. For example, if the price of a certain good increases, consumers may switch to a similar good that costs less. That kind of substitution is captured in the calculation of the index.

The goods and services that comprise larger shares of consumer expenditures will have higher weight in the index. Thus, changes in prices of goods and services with higher weight will have more influence on the inflation rate.

“Headline” vs. “Core”

For both of these price indexes, you can look at the following common measures (although there are numerous other measures available as well):

• A “headline” measure, which is an all-items or overall index.
• A “core” measure, which excludes food and energy prices.

People sometimes look at core measures to get a sense of underlying inflation trends. The graph below shows headline and core CPI inflation.

This one, below, shows headline and core PCE inflation.

In both graphs, you can see that headline inflation fluctuates more than core inflation does. You can also see from the figures that CPI inflation has tended to be higher in recent years than PCE inflation.

What the Fed Considers When Setting Monetary Policy

When it comes to setting monetary policy, the Fed’s main monetary policymaking body (the Federal Open Market Committee, or FOMC) keeps tabs on various inflation measures, including those described above. But the Fed’s 2 percent inflation target is based on headline PCE inflation.

As St. Louis Fed President James Bullard detailed in a 2012 Regional Economist article, “The FOMC will target the headline inflation rate as opposed to any other measure (e.g., core inflation, which excludes food and energy prices) because it makes sense to focus on the prices that U.S. households actually have to pay,” he wrote.

And as to why the PCE index beats out CPI, Bullard wrote in a 2013 Regional Economist article: “The FOMC focused on CPI inflation prior to 2000 but, after extensive analysis, changed to PCE inflation for three main reasons: The expenditure weights in the PCE can change as people substitute away from some goods and services toward others, the PCE includes more comprehensive coverage of goods and services, and historical PCE data can be revised (more than for seasonal factors only).”

Note: With this background on price indexes and inflation, next week's blog post will discuss the Fed’s inflation target in more detail.

Additional Resources

Curious about other kinds of price indexes? Check out the data series available in FRED, the St. Louis Fed’s free database. And for further reading on inflation, see:

• Economic Lowdown podcast: Inflation
• Regional Economist: President’s Message: Recent Actions Increase the Fed’s Transparency
• Regional Economist: President’s Message: CPI vs. PCE Inflation: Choosing a Standard Measure