An inflation index is a tool used to gauge broad price changes in an economy over time.
Learn how an inflation index works, see some well-known ones, and find out what some of the critiques of the tool are to better grasp 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 a group of many items at one time to the price of that same item or items at another time. But it's commonly shown as a whole number such as 100.
How an Inflation Index Works
To grasp the concept of an inflation index, it's vital to grasp the meaning of "index." Simply stated, an index a ratio that compares the value of one thing to another thing. It allows you to view the first thing in terms of its relative value when compared to that of the other thing.
The index model is used in many areas of finance and economics. This includes measures such as the stock market (the Dow Jones Industrial Index, for instance), wage levels, and labor yield. It allows you to compare conditions now with how they were in the past. An inflation index is used to look at the rate of inflation and thereby gauge changes in the general price level over time. When price levels rise, it's known as inflation. When price levels fall, it's known as negative inflation or deflation.
The ways to measure inflation differ. That is why there is more than one index to look at it. To figure out the Consumer Price Index (CPI), the most widely used way of looking at inflation in the U.S., the Bureau of Labor Statistics (BLS) visits thousands of places throughout the country. Each month, the BLS looks at retail stores, medical facilities, and other places to find out what people are paying for goods and services. The BLS identifies the prices of around 80,000 items per month. These prices are used as a sample to find the CPI and report it monthly. The CPI index value is found by dividing the current cost of the group of goods and services, which is called a market basket, with the cost of the same market basket in a base period and then multiplying the result by 100. For instance, an index value of 107 shows 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.
Knowing the rate of inflation is crucial because it allows central banks to enact fiscal policies that keep inflation at a rate that keeps jobs and prices stable. The rate of inflation is used for governments to create budgets. They also use the rate when called upon to enact so-called "escalation" agreements for workers such as insurance policies with inflation adjustments, collective-bargaining agreements, and rental contracts.
A common way to find out the rate of inflation is by figuring out the change in the index from one point in time to another. For instance, the CPI for All Urban Consumers (CPI-U), which can be used to find out inflation for all urban consumers in the U.S., grew from 256.39 in May 2020 to 269.20 in May 2021, representing an inflation rate of 5% over the year.
Types of Inflation Indexes
There are a few well-known inflation measures that investors and economists follow:
- Consumer Price Index (CPI): The CPI is the index used the most to track inflation in the U.S. This index tracks the change in prices that consumers pay for day-to-day living expenses. There are a few versions of the CPI. These include the CPI-U, a more broad index, and the CPI for Urban Wage Earners and Clerical Workers (CPI-W), a more specialized index that tracks prices that affect hourly wage and clerical workers. 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 a former year called the baseline year.
- Producer Price Index (PPI): This index tracks changes in the selling prices that domestic producers are offered on the goods and services they make. It is used to track inflation in the production phase. In other words, it shows price changes from the standpoint of the seller versus the buyer as in the case of the CPI. The price of steel and aluminum for car manufacturers, for instance, is tracked by the PPI.
- Employment Cost Index (ECI): This index follows changes in the cost of hiring workers in various fields and can be used to gauge inflation in the labor market.
- Gross Domestic Product (GDP) Deflator: This index tracks the changes in the prices of goods produced domestically. This includes those exported abroad but excludes imports. It's used to gauge inflation for 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 BLS into eight sections: 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 CPI was originally based on a fixed market basket of goods of fixed amounts and from fixed outlets. This approach did not look at how consumers will replace certain goods for others to keep costs down. In the view of some, this led to inflation numbers being wrong. In 1999, the BLS started to use a formula for CPI that showed changes in consumer buying habits to account for the substitution of one good for a cheaper one or from another outlet as prices change. That is, if the price of one type of ground beef goes up too much, people 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 does not show the true rate of inflation because it ignores a certain livable amount of inflation that reduces consumers' standard of living. Defenders might say it's more accurate because it reflects what people really do when they see higher prices for an item they need. The BLS itself defends the formula change by noting the following:
- The CPI only reflects changes in spending that would achieve the same standard of living.
- Substitutions aren't always made for a less desirable good.
- When changes are made, the formula only considers changes made within item categories. For example, the BLS doesn't assume that people substitute ground beef for steak as steak prices rise. These are in different item categories.
- An inflation index tracks broad price changes over time.
- You can measure the rate of inflation by finding 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. Proponents claim that the current approach is more accurate because it accounts for item substitutions.