Measuring inflation is crucial to making sound economic policy, and it’s the job of the U.S. Federal Reserve to maintain a target inflation rate of 2%. A little bit of inflation is considered desirable, driving economic growth by spurring spending. But rapidly increasing inflation can  have negative effects. It can result in depreciation of people’s savings and a loss of purchasing power, and it can affect a country’s ability to compete in the global economy—a high inflation rate can make a country’s exports more expensive, causing its trade partners to look elsewhere for goods. 

Understanding the inflation rate also helps consumers decide how to manage their personal finances and investments. A steep rise in inflation can affect consumer decisions about where to spend and where to cut back, and whether to substitute some less expensive items for their usual purchases.

What is inflation?

Inflation

is the loss of purchasing power over time because of rising prices for a broad range of goods and services. Inflation affects consumers by lowering the value of currency and can happen if the supply of money grows faster than a nation’s economic output. A dollar that is losing value buys fewer goods and services, meaning that the cost of living in general goes up. 

For instance, in the U.S., inflation averaged a healthy 1% to 3% between 2010 and 2020, but then rose to 9.1% in the 12 months ended June 2022, reaching a near 41-year high,according to Bureau of Labor Statistics data. That means that a consumer who spent $100 in June 2022 would have spent roughly $91.50 for the same basket of goods a year earlier. If inflation were to stay at 9.1% during the next year, a consumer would spend about $109 in June 2023 to buy the same things that $100 purchased in June 2022.

A combination of factors caused inflation to steeply rise, including a reopening of businesses as the Covid-19 pandemic eased, supply-chain bottlenecks, federal stimulus spending that put more money into the economy, and historically low interest rates that encouraged borrowing and spending.

How to calculate the inflation rate

The inflation rate, or the rate at which prices rise over time, is typically expressed as a percentage that indicates a year-over-year rate of increase.  The rate is measured by the change over time in the value of a price index, of which there are several. The formula for deriving the inflation rate is:

 Inflation rate = (final price index value – initial price index value / initial price index value) x 100

For example, if the initial value for an index is 100 and one year later it’s 105, the calculation would be as follows:

            105-100/100 x 100 = 5

In this case, the inflation rate after one year is 5%.

To show the rate for a 12-month period, the BLS takes the following steps:

1. Find the price index data for either the consumer price index (CPI) or the personal consumption expenditures price index (PCE) for the beginning and end dates of the period to be measured. The BLS provides these index figures, which represent averages of a wide variety of goods and services rather than a rate increase for a single item.
2. Insert the most recent and past index values into the formula and find their difference.
3. Divide the difference by the initial index value.
4. Multiply the result by 100 to get a percentage rate of inflation.

This calculation also is used to determine the rate of increase in a single item over time (B=final cost, A=initial cost): 

                                                       ((B-A)/A) x 100

For instance, imagine a pound of bacon that cost $5 in September 2021 and $7 in September 2022. The inflation calculation would be:  

1. $7-$5=$2

2. $2/$5=0.4

3. 0.4 x 100 = 40%

The inflation on a pound of bacon in this period was 40%.

Types of price indexes

There are different types of price indexes, which take different approaches to calculating price increases. The most frequently used are the consumer price index (CPI) and the personal consumption index (PCE), but there are others.

Consumer price index

The CPI is a metric the BLS has devised to measure the percentage change in the prices of about 80,000 goods and services for all urban consumers. The figure is calculated as a weighted average (meaning more costly goods count more in the index calculation) that represents an aggregate, or total, of U.S. consumer spending. This is the most widely cited inflation gauge, and BLS releasesmonthly numbers, which show the index increase for the month, seasonally adjusted, and for the past 12 months. 

Personal consumption expenditures price index (PCE)

This index, published by theBureau of Economic Analysis, tracks a different set of goods and services than CPI. Rather than a fixed basket of goods and services, it analyzes the prices of goods people are actually buying each month. This is the preferred metric the Fed uses to measure inflation. It also includes some expenditures that CPI excludes, such as healthcare that is not paid for directly, like Medicare, Medicaid, and insurance paid for by employers. 

Producer price index (PPI)

This index,reported by BLS, tracks wholesale prices of physical goods and adds services to the basket. PPI eliminates some taxes in the prices it tracks. Because the prices for sellers and retail buyers may differ significantly due to sales and excise taxes, distribution, and other added costs, PPI can be a revealing number from the wholesale perspective. This index came into use in 1978, replacing the wholesale price index (WPI), which tracked only the prices of goods before they reached the retail consumer. 

How to calculate the inflation rate when it’s over 100%

The same equation used to calculate the inflation rate applies to measuring inflation when it exceeds 100%. When the average inflation rate reaches 100%, that means the average price of goods and services has doubled. Currently, the BLS uses 1982-84 as its base year. It does this by setting the average index level for a 36-month period to 100, then measuring any changes against it. When rates rise more than 100%, the BLS selects a new base year.

For example, if a bag of popcorn cost $2 in 2006 and $5.50 in 2019, you can plug these numbers into the equation. The difference between the later and the originating price is $3.50. Divide the difference by the base price of $2 and the result is 1.75. Multiply the number by 100, and you’ll see that the price of popcorn rose 175%. The inflation rate more than doubled on popcorn since it is more than 100%.

The bottom line

Inflation is the rise in prices over time for a large basket of goods and services, resulting in a loss of purchasing power for buyers. The Fed pays close attention to the inflation rate and is charged with keeping it from being too high or low. When inflation rises steeply, the Fed may raise interest rates to curb spending. There are positive and negative effects of inflation, and the Fed tries to maintain a 2% annual inflation rate to expand the economy in a stable way to ensure economic growth and keep consumers spending.

The basic inflation rate formula shows the percentage increase in costs (or decrease, which is rare) in a certain period. Understanding inflation figures into investment strategies and planning for retirement, as well as spending on everyday goods and services.