Defining Inflation and Why It Occurs - Part I

1. What inflation is — and how economists gauge it

1. Definition and measurement

Inflation is the sustained increase in the general price level that chips away at the buying power of money; each dollar buys a little less whenever the broad basket of goods and services becomes more expensive.^[1] Economists track that erosion with price indexes such as the U.S.

Consumer Price Index (CPI), which covers about 93 percent of urban consumers and is published monthly by the Bureau of Labor Statistics.^[2] The May 2025 release put headline CPI at 2.4 percent year-over-year, comfortably below the pandemic-era peak yet still enough to nibble away at real wages.^{inflation rises 0.1 % in May 2025" target="_blank" rel="noopener noreferrer">[3]} Central banks therefore set explicit targets—usually near 2 percent—because a small, predictable rise greases economic wheels by encouraging timely spending and investment, whereas sharp or erratic swings distort contracts, unsettle financial markets, and hit fixed-income households hardest.^[4]

2. Why prices rise

Prices climb for three main reasons:

• Demand-pull inflation emerges when consumers, firms, or governments attempt to buy more than the economy can produce, often after fiscal stimulus or low interest rates flood the system with cash.^[5]
• Cost-push inflation starts on the supply side when wages, energy, or other inputs spike; producers pass those higher costs to shoppers. The 1973-74 OPEC oil embargo is a textbook case.^[6]
• Built-in (expectations-driven) inflation grows out of a wage-price spiral: if workers and firms anticipate future price hikes, they lock raises and escalators into contracts, effectively baking in the next round of increases.^[7]

Most modern flare-ups combine these channels. Post-pandemic shortages (cost-push) collided with pent-up household demand (demand-pull) and rising expectations in 2021-22, prompting central banks worldwide to launch the fastest rate-hiking cycle in four decades.

2. How three big price indexes take the economy’s temperature

1. What the CPI actually measures

The Consumer Price Index (CPI) measures the average change in prices paid by urban consumers for a basket of goods and services. Released each month by the Bureau of Labor Statistics, the CPI family tracks more than 200 categories grouped into eight broad spending classes and represents about 94 percent of the U.S. population.^[8] Price collectors visit or phone thousands of outlets in three pricing “waves,” then weight the results with data from the Consumer Expenditure Survey.

Because the basket is fixed for two years at a time, the CPI is easy to understand and is written into law for cost-of-living adjustments (COLAs) that lift Social Security, veterans’ benefits, and many private contracts.^[9] Yet that clarity comes with trade-offs: the index excludes rural households, depends heavily on rent estimates, and tends to run a bit hotter than broader gauges.

Economists therefore treat the CPI as a close-up snapshot of consumer inflation rather than a panoramic view of economy-wide price pressures, but for anyone trying to keep a paycheck, pension, or grocery budget in line with fast-moving prices it remains the most visible—and politically sensitive—number in town.

2. Why businesses and households watch CPI for short‐term moves

Understanding the CPI is indispensable for short-term economic planning because it is the metric that most quickly shows up in paychecks, leases, and government checks. Employers refer to the latest monthly reading when deciding whether to grant COLA clauses or one-off wage bumps, while landlords use it to justify annual rent increases.

The Treasury indexes Series I savings-bond rates directly to the CPI-U, and the Internal Revenue Service adjusts more than forty tax brackets and deductions with the same figure, preventing “bracket creep” in high-inflation years.^[10] Even portfolio managers who ultimately care about real (inflation-adjusted) returns watch the CPI print at 8:30 a.m.

Eastern because a stronger-than-expected number can jolt Treasury yields and equity valuations within minutes. In short, the CPI is the economy’s early-warning siren: it may not give the most nuanced reading of underlying forces, but it rings first—often weeks before broader series are available—giving households and firms the precious lead time they need to hedge, renegotiate, or simply postpone big-ticket purchases until the dust settles.

3. PCE and the GDP deflator: broader lenses on inflation

Personal Consumption Expenditures (PCE) and GDP deflator are alternative measures with different scopes and implications.

The PCE price index, calculated by the Bureau of Economic Analysis, covers all household spending—including items paid on consumers’ behalf, such as employer-provided health insurance—and updates its weights every month, allowing it to reflect substitution away from goods that suddenly become expensive.^[11][12] Because of that flexibility, the Federal Open Market Committee has targeted 2 percent inflation as measured by headline PCE since 2000.^[13] The GDP deflator pushes the aperture wider still: it compares nominal to real GDP, capturing prices of everything produced domestically—consumer goods, investment equipment, government services, and exports—while excluding imports.^[14] As a result, the deflator is invaluable for long-run growth analysis but arrives quarterly and can be revised for years.

When strategists line the three series up, they usually find that CPI runs slightly hotter than PCE, and both outpace the deflator in periods when import prices are falling or productivity is surging.

References

1. [1] IMF – Inflation: Prices on the Rise
2. [2] BLS – CPI Home
3. [3] CNBC – U.S. inflation rises 0.1 % in May 2025
4. [4] Investopedia – When Is Inflation Good for the Economy?
5. [5] IMF – Inflation: Prices on the Rise
6. [6] Investopedia – Cost-Push Inflation
7. [7] Investopedia – Inflation: What It Is and How to Control It
8. [8] BLS CPI FAQs
9. [9] Investopedia—Is CPI the best measure?
10. [10] BLS CPI FAQs
11. [11] Federal Reserve—Why PCE?
12. [12] Cleveland Fed—Differences CPI vs PCE
13. [13] St Louis Fed—Targeting PCE
14. [14] BLS—Comparing CPI and GDP deflator