Price Inflation

What Is Price Inflation?

Price inflation is an increase in the price of a standardized good/service or a basket of goods/services over a specific period of time (usually one year).

Understanding Price Inflation

The nominal amount of money available in an economy tends to grow larger every year relative to the supply of goods available for purchase. This overall demand-pull tends to cause some degree of price inflation — when there's not enough supply to satisfy demand, prices usually move upward.

Price inflation can also be caused by cost-push, which is when the cost of inputs to the production process increases. If a company has to pay higher wages and more for the raw materials it uses to make the final product, a large chunk of these extra expenses will likely be passed on to the customer in the form of higher prices.

Price inflation can also be seen in a slightly different form, where the price of a good is the same year-over-year (YOY) but the amount of the good received gradually decreases. For example, you may notice this in low-cost snack foods such as potato chips and chocolate bars, where the weight of the product gradually decreases, while the price remains the same.

Measuring Price Inflation

The consumer price index (CPI) is the most common measure of price inflation in the U.S. and is released monthly by the Bureau of Labor and Statistics (BLS). Other measures for price inflation include the producer price index (PPI), which measures the increase in wholesale prices, and the employment cost index (ECI), which measures increases in wages in the labor market.

In April 2021, the Consumer Price Index increased 0.8% on a seasonally adjusted basis after rising 0.6% in March. When compared to the year prior, the full index increased 4.2%, making it the largest 12-month increase since September 2008.

How Price Inflation Is Used

Price inflation is a critical measure for central banks when setting monetary policy. When price inflation is rising at a faster pace than desired, a central bank will likely tighten monetary policy by increasing interest rates. In an ideal world, this would encourage savings through higher returns and slow spending, which would slow price inflation.

On the other hand, should inflation remain subdued over a period of time a central bank will loosen monetary policy by reducing interest rates. Cheaper borrowing costs are supposed to incentivize spending and investing activity, spurring demand and creating price inflation.

In general, a price inflation rate of 2% in the U.S. is considered desirable.