How To Calculate An Inflation Rate: Step-By-Step
Whether we like it or not, the inflation rate impacts budgets across the country. A high inflation rate diminishes purchasing power, which makes it harder for everyone to make ends meet. Learning how to calculate the inflation rate can help you plan your budget.
Let’s take a closer look at how you can calculate this critical number.
What Is An Inflation Rate?
The inflation rate represents the rate at which prices of goods and services change over a set period of time. Our focus is usually on inflation and rising prices. But falling prices are also possible, which results in negative inflation or deflation.
Typically, the inflation rate is expressed as a percentage. As the inflation rate rises, purchasing power for consumers erodes. In other words, your dollar is worth less today than it was last month when inflation is on the rise. As purchasing power decreases, it gets more challenging for households to keep up with the rising cost of living.
How Can You Measure The Inflation Rate?
The inflation rate has a major impact on the economy. So, it’s not surprising that government keeps track of this number. Specifically, the Consumer Price Index and the Personal Consumption Expenditures Index offer a close look at the inflation rate.
Here’s what you need to know about each.
Consumer Price Index
The U.S. Bureau of Labor Statistics (BLS) publishes a monthly report to track the Consumer Price Index (CPI). The CPI reflects the spending patterns of urban consumers, which represent 93% of the U.S. population.
Essentially, the CPI looks at a basket of goods that everyday Americans buy. Commodities in the CPI include:
- Prescription medications
Each year, the basket of consumer goods changes to reflect changing consumer spending habits. While some items, like gasoline, always remain in the basket, other things, like the types of food considered, change regularly.
Personal Consumption Expenditures Price Index
The Bureau of Economic Analysis (BEA) measures the inflation rate through its Personal Consumption Expenditures Price Index (PCE).
The PCE doesn’t limit itself to the shopping carts of urban residents. Instead, it extends itself to include the change in goods and services consumed by all households. Additionally, it includes the changes in prices for goods and services consumed by nonprofits serving households.
With this baseline difference, the PCE looks at expenses that consumers don’t directly pay. And the PCE ignores fluctuating food and energy prices altogether. A few of the expenses that the PCE tracks include:
- Employer-provided insurance
Importantly, the Federal Reserve values the PCE as the most accurate measure of the country’s average inflation rate. If the inflation rate isn’t at the Federal Reserve’s target rate of 2%, they could raise or lower interest rates to impact the economy on a big scale.
How To Calculate An Inflation Rate In 5 Steps
Although you can use an inflation calculator, it’s relatively easy to make this calculation. Let’s explore the five simple steps you can take to determine the inflation rate for an item.
Step 1: Determine The Time Frame
Inflation measures the change in price over time. With that, you’ll need to determine a time frame to get started.
You can select a time frame of months, years or even decades. The right time frame varies based on your goals. For example, if you want to determine how your purchasing power stacks up compared to last year, then a single year will suffice. But if you want to compare purchasing power to whenever your parents were starting out, decades might be required.
Step 2: Gather Price Data
With your time frame in mind, it’s time to find the price information for the specific product or service. If you are looking for the average cost of an item, then check out the BLS’s CPI data. You’ll find a suite of information about pricing information for several years.
For example, let’s say you want to calculate the inflation rate of a loaf of white bread. As of January 2012, the average cost of a loaf of white bread was $1.423. But one decade later, in January of 2022, the average cost of a loaf of white bread was $1.555.
You can dig around for the right information for your specific item in question.
Step 3: Record The Information
As you gather the information, you can record in any way you see fit. But I recommend using a simple chart to help you stay organized throughout the process.
Here’s an example of how to organize the information:
Month and Year
Bananas cost per lb.
Step 4: Fill Out The Inflation Rate Formula
With the information in hand, it’s time to pull the numbers into the inflation rate formula.
Here’s the formula:
Inflation Rate = ((B − A) ∕ A) ✕ 100
Importantly, the base year will take the place of “A” and “B” will be the current year, or later date. Let’s look at an example involving the price of bananas.
Inflation Rate = ((0.63 − 0.604) ∕ 0.604) ✕ 100
Step 5: Calculate The Rate
Now it’s time to calculate your inflation rate. Don’t forget to subtract A from B before you divide by A.
Here’s how the formula works out:
Inflation Rate = ((0.63 − 0.604) ∕ 0.604) ✕ 100 = 4.3%
Of course, your numbers will look a little bit different based on your good or service. But it’s a useful calculation to run on some of your most used items.
How To Calculate The Rate Of Inflation With CPI
If you want to look at the rate of inflation beyond a single good or service, using the CPI is a good place to start. Here’s a look at the formula you can use:
CPI = (Value Of Current Market Basket ∕ Value Of Market Basket In Base Year) ✕ 100
You can use the formula to determine how the cost of goods and services is changing over time. As you run the numbers, feel free to add or subtract particular items that you don’t use. For example, if you never eat bananas, you could remove them from the value of the market basket to get a more accurate look at your changing costs.
Why Should You Calculate The Inflation Rate?
The inflation rate has a big impact on wallets across the country. One reason to track it is the impact it could have on your budget. As the inflation rate rises, you may need to adjust your spending behaviors to make ends meet.
Additionally, the inflation rate has an impact on the Federal Reserve’s decisions to raise or lower the fed funds rate. If the inflation rate is over the 2% target rate, then the Fed will likely raise interest rates to tame rising costs.
As the federal funds rate rises, it gets more expensive to make big purchases due to higher financing costs. For example, a high inflation rate could eventually impact what interest rate you get on a mortgage.
With the major impacts of inflation, it’s never a bad idea to keep tabs on this number. Plus, it’s a good way to see how your purchasing power is changing over time. If you are frustrated that your dollars aren’t stretching as far as they used to, running the numbers of inflation rate can help you see why.
The Bottom Line
As inflation rises and falls, it makes a big impact on everyone’s wallets. Unfortunately, a rising inflation rate often makes homeownership more expensive. Mortgage rates usually rise when inflation is high, and the cost to maintain your home gets higher.
If you are looking to buy a home in the future, take some time to learn how to determine if now is a good time to buy a house.