Inflation on one page
What the CPI really measures, why the target is 2%, and why prices never come back down.
How it is measured
Statisticians assemble a basket of hundreds of goods and services a typical household buys: bread, rent, petrol, haircuts, an internet subscription. Every month they check the price of that same basket again.
The percentage difference compared with the same month a year earlier is the annual inflation rate. That is the figure that shows up in the headlines as "CPI".
Each item is weighted by how much people spend on it. Rent carries a lot of weight; salt barely any. That is why your personal inflation can look quite different from the official number.
Headline and core
Headline inflation includes everything, food and energy too. Those two swing sharply for reasons that have nothing to do with the economy — a drought, a war, an OPEC decision.
Core inflation strips both out. It is steadier and gives a better picture of where the underlying trend in prices is heading.
That is why central banks always talk about core inflation, while people feel the headline number. When you hear "inflation is falling" but your electricity bill keeps rising, this is the reason.
Why 2% and not zero
Most central banks aim for around 2%. Zero would be dangerous: it leaves very little room before the economy slips into deflation, where prices fall.
Deflation sounds nice, but it is destructive. If prices will be lower tomorrow, people put off buying today; demand falls; companies lay off workers; demand falls even further.
One more thing that surprises people: when inflation drops from 8% to 2%, prices do not come back down. They simply rise more slowly. The old level never returns.
What each number means
| Measure | What it includes | Who watches it |
|---|---|---|
| Headline CPI | Everything | The public, trade unions |
| Core CPI | Excludes food and energy | The central bank |
| Inflation expectations | What people expect | The central bank |
Key terms in this lesson
- Inflation
- The general rise in prices and the loss of purchasing power that comes with it.
- CPI
- The consumer price index — the main measure of inflation.
- Core inflation
- Inflation excluding food and energy, the most volatile items.
- Deflation
- A general fall in prices. Rarely a good thing: it delays spending and slows the economy.
Quick check
Inflation falls from 8% to 2%. What happens to prices in the shops?
Progress is saved on this device only.