Economic Fundamentals
What Is Inflation? CPI, PCE & What Executives Need to Know
Inflation measures the rate at which prices rise across the economy. Understanding CPI vs. PCE and core vs. headline inflation is essential for pricing, wage, and investment decisions.
Inflation is the rate at which the general level of prices for goods and services rises over time, eroding purchasing power. The Federal Reserve targets 2% annual inflation as consistent with a healthy economy.
CPI vs. PCE — Two Measures of Inflation
The Consumer Price Index (CPI), published by the Bureau of Labor Statistics, measures the price changes of a fixed basket of goods and services purchased by urban consumers. The Personal Consumption Expenditures (PCE) price index, published by the Bureau of Economic Analysis, measures price changes for all consumer spending and allows for substitution between goods.
The Fed officially targets PCE inflation at 2%, but CPI receives more media attention because it's released first. PCE typically runs 0.3-0.5 percentage points below CPI.
Core vs. Headline Inflation
Headline inflation includes all items, including volatile food and energy prices. Core inflation excludes food and energy, providing a cleaner signal of underlying price trends. The Fed focuses on core PCE because food and energy prices are driven by supply shocks (weather, geopolitics) rather than monetary conditions.
Why Inflation Matters for Business
Inflation affects every business decision: pricing strategy, wage negotiations, input costs, interest rates, and capital allocation. When inflation runs above the Fed's 2% target, the central bank raises interest rates to cool demand — increasing borrowing costs across the economy. For executives, understanding the trajectory of inflation is critical for budgeting, pricing power assessments, and debt management.
How Inflation Is Measured
BLS surveys prices at approximately 23,000 retail and service establishments across 75 urban areas monthly. The basket weights are updated every two years based on consumer expenditure surveys. Major categories include housing (33%), transportation (17%), food (14%), and medical care (7%).
Related Indicators
All Indicators →Related Guides
All Guides →GDP Explained
Gross Domestic Product (GDP) measures the total value of all goods and services produced in a country. It's the single most important measure of economic health.
Fed Funds Rate Explained
The federal funds rate is the interest rate banks charge each other for overnight loans. It's the Federal Reserve's primary tool for controlling inflation and influencing the economy.
Yield Curve Explained
The yield curve plots Treasury bond yields across different maturities. When it inverts (short-term rates exceed long-term rates), it has historically predicted every U.S. recession.
Primary Sources
Frequently Asked Questions
What is the difference between CPI and PCE?
CPI measures prices of a fixed basket of goods and is published by BLS. PCE allows for consumer substitution between goods and is published by BEA. The Fed targets PCE at 2%. PCE typically runs 0.3-0.5% below CPI because it accounts for consumers switching to cheaper alternatives when prices rise.
Why does the Fed target 2% inflation?
The Fed targets 2% because moderate inflation gives the economy room to grow without overheating. Zero inflation risks deflation (falling prices), which can trigger a debt spiral and recession as consumers delay purchases. A 2% target also gives the Fed room to cut real interest rates below zero during downturns by setting nominal rates near zero.
How does inflation affect business strategy?
Inflation affects pricing power (can you pass costs to customers?), wage pressure (employees demand raises to maintain purchasing power), input costs (raw materials, energy, shipping), interest rates (the Fed raises rates to fight inflation, increasing borrowing costs), and investment returns (inflation erodes the real value of fixed-income investments and cash holdings).