By Daniel Sichel
Measuring inflation—the rate of change in the level of prices—requires comparing the prices of a basket of goods and services over time. While that idea sounds straightforward in principle, measuring inflation in practice is more complicated . What goes into the chosen basket of items whose prices are to be tracked over time and how prices of these different components are combined can vary from one inflation gauge to another.
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That being said, no matter how you measure it, inflation is the highest it has been in the United States in decades. Some measures of inflation aim to capture changes in the overall cost of living while others are intended to gauge a more generalized trend. Moreover, the rate of inflation experienced by different households and different sectors of the economy can range widely.
The most widely watched and reported measure of inflation is the consumer price index (CPI), compiled by the Bureau of Labor Statistics (BLS) in the Labor Department. In June 2022, the headline CPI indicated that prices were 9.1% higher than a year earlier—a 40-year high. Inflation as measured by the CPI surged since the middle of last year—to rates well beyond what most forecasters had anticipated as the economy first emerged from the pandemic (see chart).
Inflation was pushed higher by a perfect storm of factors—supply-chain disruptions, spending that ran ahead of the economy’s ability to produce goods and services fueled in part by considerable government stimulus, and shocks to food /zigman2/quotes/210389638/delayed W00 +1.54% /zigman2/quotes/210112807/delayed LC00 -0.20% /zigman2/quotes/209710348/delayed C00 +0.26% and energy prices /zigman2/quotes/209723049/delayed CL00 +2.93% /zigman2/quotes/210286597/delayed RB00 +3.95% /zigman2/quotes/210189548/delayed NG00 -2.38% related to the war in Ukraine.
Versions of the CPI are used to index Social Security benefits, some wage contracts, and some U.S. government bonds . The CPI also is used more informally to gauge changes in the cost of living by households, businesses, analysts, and the media.
By design, official measures of inflation like the CPI capture the experience of an “average” urban household, and many people experience higher or lower inflation than reported by published indexes. CPI inflation is calculated by combining information on price changes for many different goods and services with data on expenditure shares that reflect the importance or weight of each item in the “average” household’s overall spending as determined by a survey of consumers.
For example, food has a weight of 13.4%, while shelter has a share of 32.3% . Because few households have spending patterns that match the average, most households experience an inflation rate that differs from the official measure. For example, food and housing generally make up a larger share of budgets of lower-income households . In times of relatively modest price changes for most items, these differences in weights have little effect on individual inflation rates. But, because prices of these items have surged recently, many lower-income households have seen higher inflation over the past year than have higher-income households.
In addition to differences in expenditure shares, different households shop in different stores and this variation also can contribute to differences in realized inflation. Given the concerns raised by increases in income inequality, expanding the capacity to estimate price indexes defined by income quintile or decile is an important area for future research (see recent report by the National Academies of Sciences, Engineering, and Medicine). Other differences in expenditure shares can also be important, such as older households tending to spend more on medical care and only a subset of households paying college tuition.
Because food and energy prices frequently are impacted by special factors—such as weather events or geopolitical instability — and can be quite volatile, analysts often focus on so-called core inflation, which gauges the rate of inflation for all items other than food and energy. In many circumstances when food and energy prices are jumping around, the core measure provides a better read on the underlying trend in inflation. With the war in Ukraine, energy prices surged 41.6% in June compared with a year earlier and food prices were up 10.4%.
These big moves pushed up the headline CPI considerably. The core CPI—which excludes food and energy prices — rose 5.9% in June from a year earlier, but that rate was well below the 9.1% headline rate of inflation. While the headline CPI was continuing to increase in June, when prices of food and energy were increasing, the core rate was down from its peak earlier in the year (though it still remained at levels not seen since the early 1980s).
At the same time, people need to purchase food and fuel on a regular basis while purchases of other items can be deferred, so the headline measure is important to understand how purchasing power is changing over time.
While the CPI has the most salience with the public, the Federal Reserve prefers a different measure—the price index for personal consumption expenditures (PCE)—that provides a better gauge of overall price changes. This measure is compiled by the Bureau of Economic Analysis (BEA) in the Commerce Department and is an input into BEA’s calculation of gross domestic product (GDP).
The PCE index differs from the CPI in two important ways that make it a preferable measure. First, it uses a formula to combine (or aggregate) prices of different items that better captures shifts in buying patterns as consumers shift purchases away from items experiencing big price increases or toward items on sale. Second, it covers a wider set of items.