Inflation is a common term you hear often in finance websites and TV channels. This post will show how exactly inflation is measured. But before, here is a simple definition:
Inflation is a measure of change in prices of goods and services with time and expressed as a percentage.
Why an Accurate Measurement of Inflation is Important
A healthy inflation rate is essential for a healthy economy. A simple analogy that will help you understand the importance is this:
If the economy is food then inflation is the salt. An optimal quantity of salt makes a healthy and tasty diet. Similarly, a healthy inflation rate is necessary for the economy to stay sound.
Monetary policies of the government are based on prevailing economic conditions. The condition of the economy is gauged by several factors. Key factors include industrial production, salaries, etc. But you should never forget a “mother-of-all” factors. And that factor is the prices of goods and services (for consumers). For example, if the prices increase beyond a point, consumers suffer. Higher inflation rates act as warning signals under such circumstances. These signals force the governments to act.
How Price Indexes Aid Inflation Measurement
Every country has own methods for measuring inflation. But universally, the measurement is through price indexes. These indexes reflect the average prices incurred by consumers. For you to understand better, consider the example of North America. Let us now discuss the prominent price indexes in the US.
Note: If you are from a country other than the US, do not worry. The basic principle of calculating inflation through price indexes is similar across countries.
The two major indexes that the US government and economists use to assess inflation are the following.
- Consumer Price Index (CPI)
- Producer Price Index (PPI)
CPI is commonly used over PPI for a reason. The reason is this index directly relates to the prices people pay at a retail level. Any increase or decrease in CPI will have a direct impact on the general public.
What is CPI and How Exactly it is Calculated?
US Bureau of Labor Statistics (BLS) is responsible for measuring CPI. Representatives conduct large-scale surveys across the length and breadth of the US. Literally, thousands of retail outlets from different parts of the country are surveyed month after month. The prices of a “sample” basket of goods and services will be recorded.
Surveyed data helps BLS to calculate aggregate indexes which in turn are used to measure inflation.
Note: From here on, whenever you encounter BLS, it means US Bureau of Labor Statistics.
How Big are the Surveys?
Keeping a tab on each and every product in every shop is not possible. Hence statisticians use data collected on a chosen set of products across a chosen of outlets. The method to identify samples (of products, retail outlets, etc) is best left to the statisticians. But you can be sure of one thing – The sample will be large and diverse enough to represent the purchasing behavior of the US population.
How Large are the Representative Samples?
Now let us discuss the massive size of the survey samples. BLS website has information about the typical number of shops, categories, localities, etc., under survey. Some key numbers are shown below.
- 23,000 – Retail Stores
- 87 – Urban Centers
- 180 – Categories
- 80,000 – Goods/Items
- 6000 – Rental Quotations
How the Prices are Averaged?
According to the BLS website, a description of the method to calculate CPI goes like this:
“CPI weights the price of each item in the market basket on the basis of the amount of spending reported by a sample of families and individuals.”
You know CPI is an aggregate measure of prices of several thousands of items. So there has to be some mechanism to arrive at an aggregate. This aggregate value is not a simple average. However, the measure employs something called “weighted average”.
Below example will help you understand “weighted average”. (If you are from a mathematical or statistical background you can skip the below example and explanation for “weighted average”.)
Note: Below example is just for illustration and the numbers do not reflect the actual weights used by BLS.
Assume you want to calculate the weighted average of price increase of two items – bread and milk. Let households from a locality spend 60% of the money on bread and 40% of money on milk.
Let the average monthly price people pay for bread be $200 and that of milk be $100.
Case I: Simple Average
The simple average of the prices of the two items
= Price of Bread + Price of Milk / 2
= 200 +100/2 = $150
Case II: Weighted Average by Money Spent
Instead of a simple average, let us now calculate the average “weighted” by the proportion of the money spent.
Weighted Average = (% Spent on Bread x Price of Bread + % Spent on Milk x Price of Milk) / (% Spent on Bread + % Spent on Milk)
60 x Price of Bread + 40 x Price of Milk / (60 + 40) = (60 x 200 + 40 x 100) / (60 + 40) = 300 + 160 / 100 = $160
Thus, for our example, the weighted average ($160) has turned out greater than a simple average ($150).
Where to Find the Inflation Measure Based on CPI?
BLS website measures and publishes CPI numbers for every month. Usually, CPI for a month is reported during the middle of the next month. For example, data for January will be published by the Feb middle.
To check the latest percentage change in CPI, head over to BLS’s CPI homepage.
A screenshot from the CPI homepage is shown below.
At the time of writing of this post, the data has been published for Jan 2018. And the value is +0.5%. This value the inflation corresponding in Jan 2018 compared to Dec 2017.
Note: The formula to calculate monthly inflation for Jan 2018 is this
Monthy Inflation as on Jan 2018
= (CPI for Jan 2018 – CPI for Dec 2017) / CPI for Dec 2017 x 100%
How to Interpret the Inflation Measure?
Now you will learn how to interpret any inflation measure. For example, consider the +0.5% measure which we just saw for Jan 2018.
There is a reason why a “+” sign is present in front of the inflation measure. The reason is the prices have risen. On the contrary, if you see a negative sign, the data denotes a deflation (prices falling). Deflation is an economist’s nightmare and denotes the prices falling.
Note: Though deflation looks good at first (due to falling prices), it is bad for the economy for several reasons. The deflation may reflect non-performing industries, unemployment, etc. More importantly, deflation increases the burden for debt repayers. (The reason is the value of money increases during deflation.) To understand deflation better, have a look at this post.
You just learned how to interpret the “+” sign in front of “0.5%”. Now let us discuss the numeric part (“0.5%”).
Assume you are the head of a family and are keeping track of expenses including grocery bills.
Assume your Dec 2017 grocery cost you $1000. If you are going to buy the same items during Jan 2018, you can expect a hike of 0.5% on $1000. Therefore, your estimated grocery bill can be calculated as shown below.
$1000 + 0.5% of $1000 = $1005
>Disclaimer: The interpretation of inflation is not as simplistic as the example you just saw. The reason is, the sample picked by the BLS is too big and the items in your grocery bill are only a tiny fraction. For example, assume you are purchasing 50 items on a monthly basis. But this number stands no comparison to 80.000 items surveyed by BLS.
So What Exactly is the Use of Inflation Measure?
Inflation gives a general sense of price rise. Since the inflation is influenced by different products and services, you can make smart decisions to optimize budget. For example, if the inflation is driven largely by gasoline prices, you can carpool frequently.
Category-Wise Inflation Measure
You saw earlier that the price survey includes 180 categories of products. The category-list is wide and covers an enormous number of items. The list encompasses food, energy (gasoline, electricity, etc), apparel, housing, other essentials, etc. But not all the categories have the same impact.
The two most important categories that have a significant impact on the inflation and hence the lives of people are the following.
Economists keenly observe the category inflation rates in addition to the overall rate. To help them (, you and everyone), BLS website displays a chart on the home page. The chart shows the price rise/fall in food, energy and remaining items as separate bars. A screenshot of such a graph at the time of writing this post is given below.
Note: If you hover your mouse over a “bar” that represents any specific category. you will see the inflation value on the tooltip. For example, at the time of writing this post, the food prices have risen by 1.7%.
Best Timeframe to Measure Inflation? Monthly or Yearly?
So for the inflation values discussed were monthly measures. For example, you will remember the screenshot from the BLS homepage which displayed the inflation for January 2018 compared to December 2017.
However, when you hear news reports saying inflation has gone up or down, the reference is usually to a different time frame. Usually, the time frame of interest is 12 months or 1-year. The central banks across the globe have specific targets for the annual inflation rates. For example, in the US, the target inflation is 2%.
Note: If inflation goes beyond 2%, the common action by the Federal Reserve is hiking interest rates. Interest rates and inflation have an inverse relationship.
How Annual Inflation is Measured
The method used to find the inflation for 12 months is similar to calculating monthly inflation. The difference lies in the data used for comparison. For example, assume you want to measure annual inflation as on Jan 2018. The formula you have to use is shown below.
Annual Inflation as on Jan 2018
= (CPI for Jan 2018 - CPI for Jan 2017) / CPI for Jan 2017 x 100%
Note: By varying the comparison data, you can measure inflation for any time frame. For example, if you want to calculate the 3-month inflation as on Jan 2018, use the below formula.
3-Month Inflation as on Jan 2018
= = (CPI for Jan 2018 – CPI for Oct 2017) / CPI for Oct 2017 x 100%
What is Seasonal Adjustment? Why is it Important?
Seasonal factors are those which influence prices for short time periods. These are one time factors like storms, floods, etc. During adverse climatic conditions, the prices rise in the short term due to higher logistics costs. Holidays are other good examples of seasonal factors. During holidays prices drop to encourage buying.
The seasonal one-off factors do not reflect the underlying economic health of a country.
Seasonal factors should not be left to skew key economic indicators like inflation. Hence, BLS takes measures to isolate the seasonal factors from CPI and other important indices.
According to the BLS, seasonal factors are outlined and finalized every February. Subsequently, the adjustments are made for the past 5 years data.
Did We Overlook the Producer Price Index?
At the start, we stated there are two indexes commonly used to measure inflation. One is CPI or Customer Price Index which we discussed elaborately. The other one is the Producer Price Index (PPI).
PPI is an aggregate measurement of selling prices of domestic producers. Producer prices do not reflect the prices that consumers pay on retail stores. Rather, we are speaking about the selling prices by manufacturers to retail outlets and other suppliers. In some countries, PPI is called Wholesale Price Index (WPI).
The producer price of an item is the result of the first commercial transaction between the producer and supplier/retailer.
Two obvious applications of inflation measured using PPI are the following:
- Inflation measured using PPI serves as a hint of what to expect in inflation measured from CPI.
- PPI inflation is used by economists, banks, and investors to work on policies at a high level (at the level of industries).
Conclusion: Importance of Precise Measurement of Inflation
As mentioned earlier, central banks, governments, and economists always keep an eye on inflation. Inflation is a key factor why interest rates are hiked or lowered. Any change in interest rates will have a cascading effect on the overall economy. More importantly, inflation serves as a mirror of people’s financial well-being. Any monetary policy should factor in inflation to meet the objectives. Hence, a precise measurement of inflation is important for any country.