Agencies use the basket to construct a price index. First, they determine the current value of the basket by calculating how much the basket would cost at today’s prices (multiplying each item’s quantity by its price today and summing up). Next, they determine the value of the basket by calculating how much the basket would cost in a base period (multiplying each item’s quantity by its base period price). The price index is then calculated as the ratio of the value of the basket at today’s prices to the value at the base period prices.
There is an equivalent but sometimes more convenient formulation to construct a price index that assigns relative weights to the prices of items in the basket. In the case of a price index for consumers, statistical agencies derive the relative weights from consumers’ expenditure patterns using information from consumer surveys and business surveys. We provide more details on how a price index is constructed and discuss the two primary measures of consumer prices—the consumer price index (CPI) and the personal consumption expenditures (PCE) price index—in the Consumer Price Data section.
A price index does not provide a measure of inflation—it provides a measure of the general price level compared with a base year. Inflation refers to the growth rate (percentage change) of a price index. To calculate the rate of inflation, the statistical agencies compare the value of the index over some period in time to the value of the index at another time, such as month to month, which gives a monthly rate of inflation; quarter to quarter, which gives a quarterly rate; or year to year, which gives an annual rate.
In the United States, the statistical agencies that measure inflation include the Bureau of Economic Analysis (BEA) and the Bureau of Labor Statistics (BLS).
Why are there so many different price indexes and measures of inflation?
Different groups typically care about the price changes of some items more than others. For example, households are particularly interested in the prices of items they consume, such as food, utilities, and gasoline, while commercial companies are more concerned with the prices of inputs used in production, like the costs of raw materials (coal and crude oil), intermediate products (flour and steel), and machinery. Consequently, a large number of price indexes have been developed to monitor developments in different segments of an economy.
The most broad-based price index is the GDP deflator, as it tracks the level of prices related to spending on domestically produced goods and services in an economy in a given quarter. The CPI and the PCE price index focus on baskets of goods and services consumed by households. The producer price index (PPI) focuses on selling prices received by domestic producers of goods and services; it includes many prices of items that firms buy from other firms for use in the production process. There are also price indexes for specific items such as food, housing, and energy.
What is "underlying" inflation?
Some price indexes are designed to provide a general overview of the price developments in a broad segment of the economy or at different stages of the production process. Because of their comprehensive coverage, these aggregate (also called “total,” “overall,” or “headline”) price indexes are of considerable interest to policymakers, households, and firms. However, these measures by themselves do not always give the clearest picture of what the “more sustained upward movement in the overall level of prices,” or underlying inflation, happens to be.
A price index does not provide a measure of inflation—it provides a measure of the general price level compared with a base year. Inflation refers to the growth rate (percentage change) of a price index. To calculate the rate of inflation, the statistical agencies compare the value of the index over some period in time to the value of the index at another time, such as month to month, which gives a monthly rate of inflation; quarter to quarter, which gives a quarterly rate; or year to year, which gives an annual rate.
In the United States, the statistical agencies that measure inflation include the Bureau of Economic Analysis (BEA) and the Bureau of Labor Statistics (BLS).
Why are there so many different price indexes and measures of inflation?
Different groups typically care about the price changes of some items more than others. For example, households are particularly interested in the prices of items they consume, such as food, utilities, and gasoline, while commercial companies are more concerned with the prices of inputs used in production, like the costs of raw materials (coal and crude oil), intermediate products (flour and steel), and machinery. Consequently, a large number of price indexes have been developed to monitor developments in different segments of an economy.
The most broad-based price index is the GDP deflator, as it tracks the level of prices related to spending on domestically produced goods and services in an economy in a given quarter. The CPI and the PCE price index focus on baskets of goods and services consumed by households. The producer price index (PPI) focuses on selling prices received by domestic producers of goods and services; it includes many prices of items that firms buy from other firms for use in the production process. There are also price indexes for specific items such as food, housing, and energy.
What is "underlying" inflation?
Some price indexes are designed to provide a general overview of the price developments in a broad segment of the economy or at different stages of the production process. Because of their comprehensive coverage, these aggregate (also called “total,” “overall,” or “headline”) price indexes are of considerable interest to policymakers, households, and firms. However, these measures by themselves do not always give the clearest picture of what the “more sustained upward movement in the overall level of prices,” or underlying inflation, happens to be.
This is because aggregate measures can reflect events that are exerting only a temporary effect on prices. For example, if a hurricane devastates the Florida orange crop, orange prices will be higher for some time. But that higher price will produce only a temporary increase in an aggregate price index and measured inflation. Such limited or temporary effects are sometimes referred to as “noise” in the price data because they can obscure the price changes that are expected to persist over medium-run horizons of several years—the underlying inflation rate.
Underlying inflation is another way of referring to the inflation component that would prevail if the transitory effects or noise could be removed from the price data. From the perspective of a monetary policymaker, it is easy to understand the importance of distinguishing between temporary and more persistent (longer-lasting) movements in inflation.
Underlying inflation is another way of referring to the inflation component that would prevail if the transitory effects or noise could be removed from the price data. From the perspective of a monetary policymaker, it is easy to understand the importance of distinguishing between temporary and more persistent (longer-lasting) movements in inflation.
If a monetary policymaker viewed a rise in inflation as temporary, then she may decide there is no need to change interest rates, but if she viewed a rise in inflation as persistent, then her recommendation might be to raise interest rates in order to slow the rate of inflation. Consumers and businesses can also benefit from differentiating between temporary and more persistent movements in inflation. For these reasons, a number of alternative measures have been developed to measure underlying inflation. READ MORE...
