Inflation

Inflation describes the rate at which prices rise across a broad set of goods and services during a period, commonly reported over a year. A price increase in one product alone is not enough to establish economy-wide inflation. Statistical agencies estimate price indexes by tracking the cost of a selected basket over time. The consumer price index (CPI) is a widely used measure of consumer-price inflation, but its population, coverage and calculation differ among countries and indexes. Other measures, such as the personal consumption expenditures price index used by the U.S. Federal Reserve, cover different spending and use different methods.

Economists distinguish several sources of upward pressure on prices. Demand-pull inflation can occur when total spending grows faster than an economy can sustainably supply goods and services. Cost-push pressures arise when disruptions or more expensive inputs, such as energy or materials, raise production costs and prices. Expectations matter too: if workers and firms anticipate continued price rises, they may incorporate those expectations into wage agreements and contracts. These channels can overlap, and the causes of a particular inflation episode are often debated; no single explanation fits every case.

When prices rise faster than a household's income, its purchasing power falls and it can afford less. Because households buy different things and have different income sources, the impact is not identical for everyone. Inflation can also redistribute real gains and losses between borrowers and lenders when loan rates are fixed and actual inflation differs from what was expected. Unpredictable price changes make it harder for households and businesses to plan, set contracts and compare costs. Falling prices across the economy, called deflation, can also be harmful when expectations of further declines lead people to postpone spending and economic activity weakens.

Central banks monitor price indexes and the persistence of price movements when setting monetary policy. When broad demand is contributing to inflation, raising policy interest rates can restrain borrowing and spending, though the effect takes time and can also slow output and employment. Supply-driven price increases may be less responsive to interest-rate changes, so the appropriate response depends on the cause, scale and durability of the shock. Many monetary authorities aim for low and stable inflation, but their mandates and targets differ by country; the Federal Reserve, for example, identifies a 2 percent longer-run inflation objective measured by the PCE price index.