What Is Inflation? How It Is Measured and What Causes It
What inflation is, how it is measured with a fixed basket, why headline and core differ, what CPI and PCE each capture, the two classic causes, and why the surprise in the print matters more than the level. Market impact is covered separately.
Inflation is the rate at which the general level of prices rises over time — equivalently, the rate at which money loses purchasing power. It is measured by tracking the cost of a fixed basket of goods and services, and the monthly release of that measurement is one of the most consequential scheduled events in financial markets. This page covers what inflation is and how it is measured; what it does to stocks, currencies, commodities and bonds is in how inflation affects markets.
Key Takeaways
- Inflation is measured as the percentage change in the cost of a fixed basket, usually reported year on year and month on month.
- Headline includes everything; core strips out food and energy to show the underlying trend.
- CPI and PCE measure similar things with different baskets and weights, and central banks watch both.
- The two textbook causes are demand outrunning supply and costs being pushed through. Most episodes are a mix.
How It Is Measured
A statistics agency defines a basket — housing, food, transport, healthcare, clothing, recreation — weights each item by its share of typical spending, and prices the basket every month. The percentage change in the basket's cost is the inflation rate.
| Measure | What it is |
| Year on year (YoY) | This month's basket cost against the same month a year ago. The headline number |
| Month on month (MoM) | Against last month. Noisier, but the earliest sign of a turn |
| Headline | The whole basket |
| Core | The basket minus food and energy, whose prices swing on weather and geopolitics rather than on domestic demand |
Core is what central banks look at for the trend. Headline is what households experience. When they diverge, markets tend to trade the one the central bank is watching.
CPI and PCE
The Consumer Price Index measures the basket a typical household buys, with weights fixed for a period. The Personal Consumption Expenditures index — the US Federal Reserve's preferred gauge — uses a broader basket including spending made on households' behalf, such as employer-paid healthcare, and updates weights as spending patterns shift. PCE typically runs a little below CPI for those reasons. See what is CPI and what is the Federal Reserve.
Other economies have their own indices — HICP in the euro area, CPI and CPIH in the UK — built on the same principle with different baskets.
What Causes It
Demand-pull. Spending grows faster than the economy can produce: strong employment, easy credit, fiscal stimulus. More money chases the same goods, and prices rise.
Cost-push. Input costs rise and are passed on: energy, wages, imported goods after a currency fall, supply disruptions. Output does not change; its price does.
Expectations. If households and firms expect inflation, they set wages and prices accordingly, and the expectation becomes self-fulfilling. This is why central banks talk about "anchoring" expectations as a goal in itself.
Most real episodes combine all three, and the policy response differs by cause — which is why the components of an inflation print matter as much as the headline.
Why the Number Moves Markets
Central banks raise rates to cool inflation and cut them when it is below target. So an inflation print is, for markets, a signal about the next rate decision, and rate expectations drive currencies, bond yields and equity valuations. See how interest rates work.
What moves the price is not the level but the surprise against the consensus forecast. A print that matches expectations is already in the price. See why markets move before economic data is released.
Worked Example: The Same Print, Read Two Ways
Headline CPI comes in exactly as forecast. Core comes in well above.
| Reading | Conclusion |
| Headline only | "In line — nothing happened" |
| Core | Underlying pressure is stronger than expected; the central bank is more likely to stay tight |
| Market reaction | Currency up, yields up, equities down — on an "in-line" headline |
The components decided the reaction. Traders reading only the headline were surprised twice: once by the move, and again by the explanation.
(Illustrative.)
What is a normal rate of inflation?
Most developed-economy central banks target around 2% a year, on the view that a small, stable rate supports growth without eroding purchasing power quickly. The target, not a fixed "normal", is the reference.
What is the difference between inflation and the cost of living?
Inflation is the rate of change in a defined basket. Cost of living is a household's actual expenses, which can move differently depending on what that household buys.
Why exclude food and energy from core?
Because their prices are driven by weather, harvests and geopolitics rather than by domestic demand, and they reverse. Core shows the trend policy can influence.
What is deflation?
A sustained fall in the general price level. Central banks treat it as a risk because falling prices encourage delayed spending and raise the real burden of debt.
Which inflation measure do traders watch most?
US CPI, for its scheduled release and market impact, and US PCE, because it is the Federal Reserve's preferred gauge. Each economy's own headline measure matters for its currency.
Related Reading
What is CPI · How interest rates work · What is the Federal Reserve · How inflation affects markets · Why markets move before economic data
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