What Is an Inflation Index?

Definition & Examples of Inflation Indexes

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An inflation index is a tool used to gauge general price changes in an economy over time.

Learn how an inflation index works, some popular indexes, and criticisms of the tool to better understand the concept of inflation.

What Is an Inflation Index?

An inflation index tracks changes in the overall price level in an economy over time. It represents a ratio of the price of an item or the collective price of multiple items at one time to the price of that same item or items at another time. But it's commonly expressed as a whole number such as 100.

How an Inflation Index Works

To understand an inflation index, it's important to grasp the definition of an "index." Simply stated, an index a ratio that describes the quantity of one thing to another thing in terms of its relative value compared to that of the other thing. The index model is used in many areas of finance and economics, including the stock market (the Dow Jones Industrial Index, for example), wage levels, and labor productivity, in order to compare conditions now with how they were in the past. An inflation index is similarly used to measure the rate of inflation and thereby gauge changes in the general price level over time, which can rise (a phenomenon known as inflation) or fall (known as negative inflation or deflation).

Granted, there are several different ways to measure inflation, leading to more than one inflation index. To calculate the Consumer Price Index (CPI), the most widely used measure of inflation in the U.S., employees of the U.S. government's Bureau of Labor Statistics (BLS) visit thousands of establishments throughout the country, from retail stores to medical facilities, and research prices monthly. They identify the prices of approximately 80,000 items per month, which are used as a sample to calculate the CPI and report it monthly. The CPI index value is typically derived by dividing the current cost of the market basket with the cost of the same market basket in a base period and multiplying the result by 100. For example, an index value of 107 represents a change in the price of a market basket from $100 to $107.

The reference base for most CPI indexes is the period from 1982–84, which equates to an index value of 100.

Measuring the rate of inflation is important because it allows central banks to enact fiscal policies that keep inflation at a rate that maximizes employment and price stability. The rate of inflation is also important for governments in establishing budgets and when establishing a so-called "escalation" agreement for workers, such as insurance policies with inflation adjustments, collective-bargaining agreements, and rental contracts.

A common way to measure the rate of inflation is by calculating the percentage change in the index from one point in time to another. For example, the Consumer Price Index for All Urban Consumers (CPI-U), which can be used to measure inflation for all urban consumers in the U.S., grew from 256.57 in July 2019 to 259.10 in July 2020, representing an inflation rate of 1% over the year.

Types of Inflation Indexes

There are several popular inflation indices that investors and economists follow:

  • Consumer Price Index (CPI): The most commonly used inflation index in the U.S., this inflation index tracks the change in prices that regular consumers pay for day-to-day living expenses. There are multiple versions of the CPI, notably the CPI-U, a more general index, and the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), a more specialized index that tracks prices affecting hourly wage and clerical workers. But all are built on the idea of tracking the price of a basket of goods and comparing it to the price of those goods in some previous year referred to as the baseline year.
  • Producer Price Index (PPI): This inflation index tracks changes in the selling prices that domestic producers are offered on the goods and services they make and is used to measure inflation in the production phase. In other words, it represents price changes from the standpoint of the seller versus the consumer as in the case of the CPI. The price of steel and aluminum for automobile manufacturers, for example, is tracked by the PPI.
  • Employment Cost Index (ECI): This inflation index follows changes in the cost of hiring employees in various fields and can be used to measure inflation in the labor market.
  • Gross Domestic Product Deflator (GDP Deflator): This inflation index tracks the changes in the prices of goods produced domestically, including those exported abroad but excluding imports. It's used to measure inflation experienced by consumers as well as the governments or institutions that supply goods and services to them.

The market goods and services used to figure the CPI are grouped by the Bureau of Labor Statistics into eight categories: food and beverages, housing, apparel, transportation, medical care, recreation and entertainment, education and communication, and other goods and services.

Criticism of Inflation Indexes

In the U.S., the widely used CPI was originally based on a fixed market basket of goods of fixed quantities and from fixed outlets, an approach that neglected how consumers substitute certain goods for others as price changes occur to minimize costs, and in the view of some, led to an overstatement of inflation. In 1999, the BLS started to use a formula for CPI that reflected changes in consumer buying habits to account for the substitution of one good for another or from another outlet as prices change. That is, if the price of one type of ground beef skyrockets, families may switch to another type of ground beef. Therefore, the price of that beef is used in the CPI instead.

Critics believe that this approach understates the true rate of inflation because it ignores a certain livable amount of inflation that ultimately reduces consumers' standard of living. But defenders might say it's more accurate because it reflects what real families do when confronted with higher prices of a specific commodity. The BLS itself defends the formula change by noting that the CPI only reflects changes in spending that would achieve the same standard of living, that substitutions aren't always made for a less desirable good, and when they are made, the formula only considers substitutions made within—not across—item categories. For example, the BLS doesn't assume that people substitute hamburgers for steak as steak prices rise, as these are in different item categories.

Key Takeaways

  • An inflation index tracks general price changes in an economy over time.
  • You can measure the rate of inflation by calculating the percentage change in the index from one point in time to another.
  • In the U.S., major inflation indexes include the CPI, PPI, ECI, and GDP Deflator.
  • Critics believe that changes in the CPI formula over time have led to the understatement of inflation, but proponents claim that the current approach is more accurate because it accounts for item substitutions.