What Is an Inflation Index?

Understanding an Inflation Index and How an Inflation Index Works

What is the definition of an inflation index?
An inflation index is a tool used to measure the rate that prices are increasing or, alternatively, money is losing its value. Economists can use an inflation index to estimate the cost of living for families, track the costs of running a business such as wages and cost of goods, and more. Image Credit: Jeffrey Coolidge / Getty Images

An inflation index is an economic tool used to measure the rate of inflation in an economy. There are several different ways to measure inflation, leading to more than one inflation index with different economists and investors preferring one method to another, sometimes strongly. This brief overview should help you understand how an inflation index works, some of the more popular models, and perhaps even help you decide for yourself the one you think represents the "true" inflation rate.

(To learn how to overcome inflation in your savings and investments, read To Beat Inflation, Focus on Purchasing Power Not Dollars.)

Before we can begin, you need to understand the definition of an "index". Simply stated, an index is just a collection of data that serves as a baseline for future reference. We use the index model in all areas of life, from the stock market (the most famous of which is probably the Dow Jones Industrial Index), to inflation. We index wage levels, corporate profits as a percentage of GDP, and almost anything else that can be measured. We do this to compare where we are now to where we have been in the past.

Popular Inflation Index Reports

There are several popular inflation index reports that investors and economists follow:

  • Consumer Price Index (CPI): This inflation index measures the change in prices regular consumers pay to live their day-to-day lives. We'll talk about it more in depth in a moment.
  • Producer Price Index (PPI): This inflation index measures the change in prices manufacturers and producers experience on materials necessary for conducting their business. The price of steel and aluminum for automobile manufacturers would be tracked by the PPI.
  • Employment Cost Index (ECI): This inflation index measures the rising cost of hiring employees in various fields.
  • Gross Domestic Product Deflator (GDP Deflator): This inflation index measures the rise in costs experienced by end consumers as well as the government or institution providing goods and services to those consumers.

The Consumer Price Index (CPI)

The CPI, or Consumer Price Index, is without a doubt the most popular inflation index in the United States. There are several different versions of the CPI but they all are built upon the idea of tracking prices for a basket of goods and comparing them to some previous year, which is often referred to as the baseline year.

According to the U.S. government, The Consumer Price Index covers different categories and items including:

  • Food and Beverages: Milk, coffee, wine, snacks, chicken, breakfast cereal, etc.
  • Housing: Rent, heating oil, bedroom furniture
  • Apparel: Shirts, sweaters, jewelry
  • Transportation: New vehicles, airline fares, car insurance, gasoline
  • Medical Care: Prescription drugs, medical supplies, doctor visits, eyeglasses, hospital bills
  • Recreation and Entertainment: Televisions, toys, pet products, sports equiment, admissions
  • Education and Communication: College tuition, postage, telephone service, computer software
  • Other Goods and Services: Tobacco, haircuts, funeral expenses, etc.

    How is the Inflation Index Updated? 

    Every month, employees of the U.S. government's Bureau of Labor Statistics visit thousands of retail stores, restaurants, service establishments, apartment buildings, and medical facilities throughout the country and research prices. It is estimated that they sample approximately 80,000 items per month, which is used as the raw data to perform the Consumer Price Index calculations that get reported to the press.

    The government even reports the inflation index for major metropolitan areas so that you can tell if prices are rising more rapidly in, say, Atlanta than they are Denver.

    Inflation Index Controversy

    It has been estimated that up to 30% of the United States Federal Budget is based upon changes in the Consumer Price Index. During the 1990's, when Bill Clinton served as President, the CPI was changed to reflect "buying habits" rather than serving as a true inflation index.

    This involved rule changes that accounted for substitution. That is, if the price of beef skyrockets, families will switch to chicken. Therefore, the price of chicken is used instead of beef. Likewise, if a product improves and remains the same price, the index is lowered to reflect the fact consumers are getting more value for their money. Some economists believe this drastically understates the real rate of inflation. Others think it is more accurate because it reflects what real families do when confronted with higher prices of a specific commodity.

    More Information About Inflation and the Inflation Rate

    To learn more about inflation and inflation rates, read The New Investor's Guide to Inflation and the Inflation Rate, a special that answers questions such as: