Inflation

Inflation is the rate at which the general level of prices rises over a period, usually quoted as the percentage change in a price index such as the Consumer Price Index over twelve months.

How inflation is measured

In the United States the most-cited inflation gauge is the Consumer Price Index, which the BLS describes as a measure of the average change over time in the prices paid by consumers for a representative basket of goods and services. National CPI figures are published monthly, and the CPI-U series covers over 90 percent of the U.S. population. Most CPI series use a 1982-84 = 100 reference base, so a level of 110 means prices are 10 percent above that base. Analysts also follow the "all items less food and energy" index, called core CPI, because food and energy prices are relatively volatile. The Federal Reserve judges inflation of 2 percent over the longer run, measured by the PCE price index, to be most consistent with its mandate for maximum employment and price stability.

Hypothetical example: an index at 300.0 that reads 309.0 a year later implies 3% inflation, so $10,000 of cash buys what $9,709 bought a year earlier. See the inflation calculator, CPI and PCE.

Why inflation matters to investors

Inflation separates a nominal return from a real return. A savings account, bond or dividend stream pays a stated number of dollars, but the goods those dollars buy shrink as prices rise, so the return that matters is the nominal return adjusted for inflation. The SEC's guide to asset allocation calls inflation risk the principal concern for investors in cash equivalents, because their low returns can be eroded over time. Inflation also drives monetary policy: the Federal Reserve raises or lowers its policy rate partly in response to how far inflation sits from its 2 percent goal, and those decisions move bond yields, mortgage rates and equity valuations. Investors watch the gap between headline and core figures, since a widening gap usually signals a shock in food or energy rather than broad repricing.

Hypothetical example: a bond yields 5% while inflation runs 3%; the exact real return is 1.05 / 1.03 − 1 ≈ 1.94%. See real yields and the real return calculator.