What is inflation, and how is it measured with the CPI?
Short answer
Inflation is a sustained rise in the general level of prices, so each unit of money buys less over time. It is usually measured by the consumer price index (CPI), which tracks the cost of a fixed basket of goods and services.
What inflation means
Inflation describes a general, sustained increase in prices across an economy, not a rise in the price of one item. When inflation is positive, the same amount of money buys fewer goods and services than before, which economists call a fall in purchasing power.
Disinflation is a slowdown in the rate of inflation: prices still rise, but more slowly. Deflation is a fall in the general price level. Neither is the same as a single price dropping.
How the CPI is built
A consumer price index compares the cost of a fixed basket of goods and services, such as food, housing, transport and clothing, in one period with its cost in a base period. Statistical agencies choose the basket from household spending surveys and weight each item by how much households spend on it.
Each country publishes its own index. The United States uses the Consumer Price Index from the Bureau of Labor Statistics, India uses a Consumer Price Index published by its statistics ministry, the United Kingdom uses the CPI from the Office for National Statistics, and the euro area uses the Harmonised Index of Consumer Prices (HICP). Baskets and weights differ, so rates are not strictly comparable across countries.
Inflation rate (%) = (CPI this period - CPI a year earlier) / CPI a year earlier x 100Headline, core and targets
Headline inflation covers every item in the basket. Core inflation excludes categories that move a lot from month to month, usually food and energy, to show the underlying trend.
Many central banks have an explicit inflation target. For example, the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan each describe a 2% objective, and the Reserve Bank of India works with a 4% target and a tolerance band of 2% to 6%. Targets are set by law or by agreement with governments and can be changed.
Real and nominal values
A nominal value is stated in the money of the day. A real value is adjusted for inflation. A deposit that pays 5% a year while prices rise 3% a year has a real return of roughly 2%. This is why interest rates and inflation are usually read together.
Approximate real rate = nominal rate - inflation rate