By Kristie Engemann, Public Affairs Staff
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?
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.
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 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.
For both of these price indexes, you can look at the following common measures (although there are numerous other measures available as well):
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.
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.
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: