Inflation – Energy = Tame?

It can be tough to swallow news reports claiming that inflation is low and under control when you are pumping $3-per-gallon gasoline. How can economists describe inflation as tame when energy prices are skyrocketing?

Inflation is usually reported as a single number, but many components go into calculating the inflation rate. By understanding the ways in which economists and policymakers look at inflation, you may be able to resolve the dissonance between what the news says and what your experience tells you.

When Inflation Spikes

Inflation in the United States is measured in several ways. Two of the most common and easy-to-understand measurements are the Consumer Price Index (CPI) and the Producer Price Index (PPI).

Each of these indexes considers many kinds of prices. The CPI looks at retail prices for such common items as food, clothing, shelter, fuel, medical costs, and other goods and services that people rely on for daily needs. The PPI looks at wholesale prices for some of the same items, plus several others.

When economists evaluate these two indexes, it is common practice to look at both overall inflation and "core" inflation, which excludes food and energy prices. Here's why.

Food and energy prices are typically more volatile than other prices. Although we tend to think of volatility as describing rising prices, it also describes falling prices. Food prices are more volatile because weather can cause problems; energy prices are affected by changing geopolitical and market conditions.

For example, when there is a spike in energy prices but prices quickly correct, the higher prices may not become embedded in the prices of goods and services that rely on energy. Thus, the higher prices will be reflected in overall inflation but probably not in the core reading. If the price spike is prolonged, economists will look for evidence that higher energy prices have driven up other prices and influenced the core inflation rate. Sometimes such evidence can be found by comparing the overall inflation rate with the core inflation rate.

Inflation can provide clues about how the economy as a whole may perform. Learning how to interpret the ways in which inflation is measured may add to your understanding.