What is inflation and how does the Federal Reserve evaluate changes in the rate of inflation?
Inflation is the increase in the prices of goods and services over time. Inflation cannot be measured by an increase in the cost of one product or service, or even several products or services. Rather, inflation is a general increase in the overall price level of the goods and services in the economy.
Federal Reserve policymakers evaluate changes in inflation by monitoring several different price indexes. A price index measures changes in the price of a group of goods and services. The Fed considers several price indexes because different indexes track different products and services, and because indexes are calculated differently. Therefore, various indexes can send diverse signals about inflation.
The Federal Open Market Committee (FOMC) judges that an annual increase in inflation of 2 percent in the price index for personal consumption expenditures (PCE), produced by the Department of Commerce, is most consistent over the longer run with the Federal Reserve’s mandate for maximum employment and price stability. The FOMC uses the PCE price index largely because it covers a wide range of household spending. However, the Fed closely tracks other inflation measures as well, including the consumer price indexes and producer price indexes issued by the Department of Labor.
When evaluating the rate of inflation, Federal Reserve policymakers also take the following steps:
- First, because inflation numbers can vary erratically from month to month, policymakers generally consider average inflation over longer periods of time, ranging from a few months to a year or longer.
- Second, policymakers routinely examine the subcategories that make up a broad price index to help determine if a rise in inflation can be attributed to price changes that are likely to be temporary or unique events. Since the Fed's policy works with a lag, it must make policy based on its best forecast of inflation. Therefore, the Fed must try to determine if an inflation development is likely to persist or not.
- Finally, policymakers examine a variety of "core" inflation measures to help identify inflation trends. The most common type of core inflation measures excludes items that tend to go up and down in price dramatically or often, like food and energy items. For those items, a large price change in one period does not necessarily tend to be followed by another large change in the same direction in the following period. Although food and energy make up an important part of the budget for most households--and policymakers ultimately seek to stabilize overall consumer prices--core inflation measures that leave out items with volatile prices can be useful in assessing inflation trends.
Federal Reserve Bank of Cleveland. "Median CPI & Inflation Measurement." (See information on the trimmed-mean Consumer Price Index.)
Federal Reserve Bank of Dallas. "Trimmed Mean PCE Inflation Rate."
U.S. Department of Commerce, Bureau of Economic Analysis. "National Economic Accounts." (See information on price indexes for personal consumption expenditures under the headings Gross Domestic Product (GDP) and Personal Income and Outlays.)
U.S. Department of Labor, Bureau of Labor Statistics. "Consumer Price Index."
U.S. Department of Labor, Bureau of Labor Statistics. "Producer Price Indexes."
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