Updated: Jul 18, 2022
What is inflation?
Inflation is a loss of purchasing power over time: "It means your dollar will not go as far tomorrow as it did today". Inflation is the increase in the prices of goods and services over time. Inflation cannot be measured by an increase in the cost of one product or service, or even several products or services. Rather, inflation is a general increase in the overall prices of the goods and services in the economy.
Fact: Inflation hit its highest level in 2021, since 1982.
What causes inflation?
Inflation can rise and fall based on growth that have little to do with economic conditions. Limited oil production can make gas expensive. Supply chain problems can keep goods in short supply, pushing up prices. If customers are buying items and services enough, businesses may need to raise prices because they lack adequate supply. Or companies may choose to charge more because they realize they can raise prices and improve their profits without losing customers. Coronavirus has also contributed to factories shutting down and has clogged shipping goods, causing additional limitation to the supply chain around the world. Do not think of inflation in terms of higher prices for just one item or service. Inflation more refers to the broad increase in prices across sectors or industries, like the energy business and ultimately a country’s entire economy.
The basic formula to calculate the inflation rate is as follows:
(Current Price – Former Price)/Former Price
When evaluating the rate of inflation, Federal Reserve policymakers also take the following steps:
First, because inflation numbers can vary erratically from month to month, policymakers generally consider average inflation over longer periods of time, ranging from a few months to a year or longer.
Second, policymakers routinely examine the subcategories that make up a broad price index to help determine if a rise in inflation can be attributed to price changes that are likely to be temporary or unique events. Since the Fed's policy works with a lag, it must make policy based on its best forecast of inflation. Therefore, the Fed must try to determine if an inflation development is likely to persist or not.
Finally, policymakers examine a variety of "core" inflation measures to help identify inflation trends. The most common type of core inflation measures excludes items that tend to go up and down in price dramatically or often, like food and energy items. For those items, a large price change in one period does not necessarily tend to be followed by another large change in the same direction in the following period. Although food and energy make up an important part of the budget for most households--and policymakers ultimately seek to stabilize overall consumer prices--core inflation measures that leave out items with volatile prices can be useful in assessing inflation trends.
Source information: https://www.federalreserve.gov/faqs/economy_14419.htm
Fact: The U.S. government publishes several inflation measures on a monthly and quarterly basis. The main measures are the Consumer Price Index (CPI) and the personal consumption expenditures (PCE) price indexes. The CPI and PCE are constructed differently and perform differently over time.