The inflation rate is the percentage increase in prices for a basket of goods and services purchased by households over a period of time. It is the metric most closely watched by policymakers and market participants because it gives a snapshot of the economic impact of relative price changes on an economy’s overall purchasing power.
Relative price changes transmit important information to consumers, producers, and workers about what they need to do in order to achieve their goals, such as buying a new car or producing enough semiconductors to meet demand. But, when inflation distorts these relative price signals, individuals may shift their resources away from activities that foster production and long-term economic growth toward protection of their wealth instead.
A well-managed central bank will seek to keep the inflation rate low enough to support a healthy economy and encourage business activity. However, the exact rate of inflation can be unpredictable as pent-up demand and supply chain disruptions can push prices higher. This is known as demand-pull inflation.
Regardless of how it is measured, the primary impact of inflation is that people’s purchasing power erodes over time because the same amount of money buys less and less. Generally, when the inflation rate is below a central bank’s target of 2 percent, the economy will grow at a steady and sustainable pace.
It is also important to note that the inflation rate differs across sectors. For example, food and energy tend to be more volatile than the rest of the economy’s prices. That is why most analysts measure the consumer price index or Personal Consumption Expenditures (PCE) to get an overall picture of inflation that excludes those volatile components.
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