Inflation Rates and How to Calculate Them

Regardless of which inflation rate you’re talking about, inflation is the pace at which prices rise. If the inflation rate is 2% a year, then prices are rising on average by 2% every year. But this doesn’t mean that every price in the economy is rising at that rate. Prices of some things might be rising faster than 2%, while prices of other things are rising more slowly or might even be falling. The average of all these price changes is the inflation rate.

If the rate of inflation falls, that doesn’t mean that prices are falling. It just means prices are rising slower. Only if the inflation rate is negative do prices fall. “Disinflation” is the word economists use to describe an inflation rate that is falling but still positive. “Deflation” is used when the inflation rate is negative, and prices are actually falling.

Deflation is most often seen when the economy is in recession, and often takes the form of heavy discounting and fire sales by stores and other companies that are doing their best to stay in business. In the U.S., deflation doesn’t usually last for long.

There are lots of different prices in the economy, and therefore lots of different types of inflation rates. There are also different ways of calculating similar types of inflation.

Consumer Price Index (CPI): This is the best-known and most widely used inflation measure. This is the rate at which consumer prices are rising. The CPI is a “basket” of consumer goods and services that represents what Americans typically buy on a monthly basis. Because the Bureau of Labor Statistics (BLS) monitors changes in the prices of these goods and services in mostly urban areas, you may also see CPI referred to as CPI-U. The BLS calculates the index and publishes it monthly.¹

It is usually quoted as a percentage rise “per annum.” So, for example, if the CPI inflation rate is 2% per annum, that means that consumer prices are, on average, rising by 2% every year. The CPI inflation rate is used to determine Social Security benefit increases, and is typically the reference rate for inflation-protected investments such as indexed government bonds and inflation swaps, which people can use to protect their savings against inflation.

Personal Consumption Expenditures (PCE): An alternative to the CPI inflation rate is the PCE inflation rate, which is calculated by the Bureau of Economic Analysis (BEA).² The PCE inflation rate is calculated in a similar way to the CPI inflation rate, but its basket of goods and services is broader.³ It tends to be slightly lower than the CPI inflation rate.

Both CPI and PCE inflation rates have two versions: the so-called “headline” rate, which is the one you will see in the press, and the “core” rate, which strips out some consumer goods and services whose prices tend to move around a lot, such as gasoline. The main job of the Federal Reserve—the U.S. central bank—is to keep inflation at around a 2% per year target, measured in terms of core PCE.

Other types of inflation rates that you may see quoted in the news include:

• Producer Price Index (PPI): the rate at which prices paid by businesses for raw materials and other supplies are rising.
• International Price Program (IPP): the rate at which import and export prices are rising.
• Employment Costs Index (ECI): the rate at which wages and other costs of employment are rising.

The BLS publishes monthly and annual CPI inflation rates—in other words, the change in prices since last month or last year. But you can use the CPI to calculate the inflation rate between any two dates. For example, let’s imagine it is December 2019 and you want to know what the CPI inflation rate has been for the past three years—since January 2017. Here’s how to make that calculation:

1. First, look up the CPI-U indexes for January 2017 and December 2019. The CPI-U index in January 2017 was 242.839,⁴ and for December 2019 was 256.974.⁵
2. Next, subtract the January 2017 figure from the December 2019 one to give the change in the index: 256.974 – 242.839 = 14.135.
3. Then divide that by the January 2017 figure: 14.135 / 242.839 = 0.0582.
4. And multiply by 100 to obtain the percentage: 0.0582 x 100 = 5.82%. 

Note that this is not an annual figure. If you want to know the average annual rate during that time, you need to divide this by the number of years: 5.82% / 3 = 1.94%.

You can use the same calculation method to work out other inflation rates from their indexes.

If you read a lot of economic news, you may come across the “GDP deflator.” This is an inflation rate calculated in an entirely different way from any of the types we have discussed so far. The GDP deflator calculates the change in prices from one period to the next across the entire economy. The BEA publishes the GDP deflator quarterly.⁶

Here's how the GDP Deflator works: GDP (“gross domestic product”) is the total value of all goods and services sold in a single year, excluding imports,⁷ and it can only increase in two ways: either prices rise, or people buy and sell more goods and services than they did last year. “Nominal” GDP growth is calculated based on current-year market prices, and so the effect of inflation is bundled in.

But economists also want to know whether businesses and consumers really are buying and selling more actual stuff. So they calculate “real” GDP, which strips out the effect of inflation, by referencing prices in a baseline year—thus excluding price rises since that year.

You would determine real GDP growth for 2019 versus 2016, for example, by recalculating 2019 sales volumes at 2016 prices. The GDP deflator is the inflation rate between those two years—the amount by which prices have risen since 2016. It’s called the deflator because it’s also the percentage you have to subtract from nominal GDP to get real GDP.