Calculate inflation from a price index, distinguish headline from core and explain its causes and costs.
Inflation is a sustained rise in the general price level. Deflation is a sustained fall. Disinflation is inflation that is slowing.
A statistical agency prices a fixed basket of goods and services that a typical household buys, weighted by spending shares, each month.
If the index moves from 150 to 156, inflation is 4%. The largest basket weights are shelter, transportation and food.
Headline CPI includes everything. Core measures strip out or down-weight the most volatile items to reveal the underlying trend. The US uses CPI excluding food and energy. The Bank of Canada watches CPI-trim (which drops the most extreme price changes each month) and CPI-median. The Federal Reserve's target is defined on a different index, the personal consumption expenditures (PCE) price index, which usually runs a few tenths below CPI.
Producer price indexes track prices at the factory gate. The GDP deflator covers everything produced. Wage growth and unit labour costs show pressure from the labour market. Inflation expectations, from surveys and from the gap between nominal and inflation-linked bond yields (the breakeven rate), show what people think will happen next.
It erodes the purchasing power of cash and fixed incomes; transfers wealth from lenders to borrowers when unexpected; distorts price signals and tax brackets; and, once high, is costly to bring down. Deflation is also dangerous: it raises the real burden of debt and encourages people to postpone spending.
The Fisher relation: nominal rate is approximately real rate + expected inflation. A 5% bond yield with 3% expected inflation offers a real yield of about 2%. Real rates drive saving, investment and asset valuations.
Most developed-country central banks target 2%. It is low enough to be ignored in everyday decisions, high enough to give room to cut real rates in a downturn, and it keeps a buffer against deflation.
Substitution (consumers switch away from items that get dearer), quality changes and new products make a fixed basket imperfect. Each household's own inflation differs from the average.
Suppose the basket has four groups.
| Group | Weight | Price change over the year | Contribution |
|---|---|---|---|
| Food | 20% | +5% | 1.0 point |
| Shelter | 30% | +6% | 1.8 points |
| Transportation | 15% | -2% | -0.3 points |
| Everything else | 35% | +2% | 0.7 points |
| Total | 100% | 3.2% |
Inflation is 3.2%, and shelter contributes more than half of it. Statistical agencies publish contributions like these, which is the fastest way to see what is driving a release.
Markets react to the month-over-month change. A 0.3% monthly rise compounds to (1.003)^12 minus 1 = 3.7% a year; 0.2% compounds to 2.4%. Central banks often watch three-month annualized rates of core inflation for a timelier signal than the 12-month figure.
The 12-month rate compares this month's index with the same month a year earlier. When an unusually large monthly jump from a year ago drops out of the comparison, the annual rate falls even if prices are rising normally now. Energy prices create large base effects.
After the pandemic, strong demand, supply-chain disruptions and then energy prices after Russia's invasion of Ukraine pushed inflation to its highest in four decades: US CPI peaked at 9.1% and Canadian CPI at 8.1%, both in June 2022. Central banks raised rates faster than at any time since the early 1980s. Inflation fell back over 2023 and 2024 without the deep recession many had expected, a result economists still debate.
Shelter is the largest category: about a third of US CPI and close to 30% of Canadian CPI. It is also slow-moving, because rents reset only when leases renew, so shelter inflation tends to lag market rents by many months.
The Bank of Canada surveys businesses and consumers quarterly; in the US, the University of Michigan and the New York Fed survey households. Long-term expectations that stay near 2% while current inflation is high are what central banks most want to see.
Unexpected inflation transfers wealth from lenders and holders of cash and fixed-income claims to borrowers, including governments with large debts. Workers whose wages lag prices lose purchasing power; owners of real assets and companies with pricing power tend to hold up better.
Statistics Canada publishes CPI monthly, as does the US Bureau of Labor Statistics. Mortgage interest cost is included in Canadian CPI, so rate increases mechanically raise measured shelter inflation at first; the US instead uses owners' equivalent rent.
From the latest CPI release in each country, record headline inflation, the core measures and the three components contributing most. Compare with the central bank's target.
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