By Frances Coppola | American Express Credit Intel Freelance Contributor
7 Min Read | June 26, 2020 in Money
For many Americans, inflation is merely something you hear about on the news, and you don’t pay it much attention. Perhaps that’s partly because the current inflation rate has been pretty low for years now, and so people don’t feel its effects. I suspect many more people would sit up and take notice if the inflation rate were as high as it was when I was a teenager in the 1970s. Back then, high inflation squeezed people’s finances pretty hard.
But low or high, inflation rates affect people’s lives. This article describes the main inflation rates that economists concentrate on, and how to calculate them. For an explanation of what inflation is and how it works, see in “Inflation 101: Meaning and Causes.”
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:
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:
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.
Inflation can seem to change in unpredictable ways, and headline figures may bear little relationship to your experience of price changes in daily life. Knowing how the various inflation rates are calculated may help you to understand the effect of inflation on your finances, and help you plan more effectively for the future.
1 “Consumer Price Index Frequently Asked Questions,” Bureau of Labor Statistics
2 “Personal Consumption Expenditures Price Index,” Bureau of Economic Analysis
3 “PCE Inflation Dispersion,” Federal Reserve Bank of San Francisco
4 “Consumer Price Index News Release January 2017,” Bureau of Labor Statistics
5 “Consumer Price Index News Release December 2019,” Bureau of Labor Statistics
6 “GDP Price Deflator,” Bureau of Economic Analysis
7 “Gross Domestic Product,” Bureau of Economic Analysis