How To Calculate The Inflation Rate: Formulas And Examples

Prices of goods and services naturally rise, level off and occasionally fall according to where we are in an economic cycle. Understanding this can be very helpful in not only knowing the state of the economy, but from a very practical perspective, how it’s affecting your wallet. We’ll go over the causes of inflation and how to calculate the inflation rate.

Inflation refers to an increase in the price for the same amount of an item or service. You can measure inflation based on price changes for a single item like a cup of coffee, but more often, it’s calculated based on a standard basket of goods and services. The opposite of inflation is deflation, when prices fall. Over time, prices tend to rise more than they drop.

The inflation rate measures the extent to which prices have risen over a given period. The result of the calculation is expressed as a percentage. The Federal Reserve (Fed) would actually like to see an average inflation rate of 2% per year. Prices rising a little bit gets people to buy, which keeps people employed. What they don’t want is for the inflation level to get too high.

There’s not one standard measure of inflation. There are a couple that are commonly looked at. The current annual rate of inflation for the Consumer Price Index (CPI) is 8.5%. Last year at this time, the annual rate of inflation was 5.4%.

Others look at the Personal Consumption Expenditures (PCE) index. In the most recently available data, this came in up 6.3%. Last July, the annualized inflation rate was 4.2%. We’ll have more on the differences between these two indexes later on. For now, just understand that which data is being looked at can make a big difference in the numbers.

An increasing inflation rate can lessen the purchasing power available to consumers and increase your cost of living. There are a multitude of market conditions that can have inflation impacts depending on what’s happening in the economy. Here are the three general buckets of inflation:

• Demand-pull inflation: This is classic supply and demand-related inflation. When one toy is the hit of the holiday season, prices rise until the level of demand matches the supply the manufacturer is able to provide. I’m sending good vibes if you’re a parent thinking about braving the Black Friday crowds.
• Cost-push inflation: In this scenario, an increase in production costs increases the cost of products and/or services. A good example of this would be the shortage of specialized computer chips for automobiles. Because these were so hard to get for a long time, the prices of both new and used cars spiked.
• Built-in inflation: Built-in inflation occurs when inflation has been high enough because of demand-pull or cost-push inflation that people start demanding higher wages to keep up. Unfortunately, this can also be the most sinister type of inflation because if people have more money, they’ll be willing to pay higher prices, and prices will keep going up. It becomes a vicious cycle.

Gross domestic product (GDP) takes a look at the overall output of an economy in order to determine how much it grew or shrank over a given time frame. In general, an economy will grow faster in times of low inflation because consumers have more money to spend.

As mentioned earlier, there are two major metrics for consumer inflation. The CPI, administered by the Bureau of Labor Statistics (BLS), asks consumers what they’re spending on various items.

The Bureau of Economic Analysis (BEA) collects data for the PCE. As opposed to asking consumers about pricing increases, the PCE asks businesses.

In theory, the records businesses have for spending and what consumers say they’re paying should match, but it doesn’t happen that way in practice. Part of the reason for this is that the two indexes assign more or less weight. It’s for this reason that the Fed and many other economists prefer the PCE.

You also should be aware of which number is being reported. Both indexes report overall inflation as well as the rate of inflation after food and energy have been taken out. Food and energy prices are considered more volatile.

Further complicating things, there are two different survey bases used when calculating CPI. The Consumer Price Index for All Urban Consumers (CPI-U) covers about 93% of the U.S. population because most live in cities.

The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) covers people who have clerical or wage-based earnings. Although it covers a smaller sample size, it is an acknowledgment of the reality that people in different financial situations buy different goods and services.

Either of these formulas can be used to calculate price changes from month-to-month or from the current year in comparison to any other year. However, it’s also important to be aware of the limitations of any index you look at.

For example, by focusing on urban consumers, the CPI ignores those in rural areas. Also among those not included are the hospitalized, incarcerated and those living on military bases.

There are a couple of different formulas that can be used to calculate inflation rate. While they’re suitable for different purposes, the one you pick may also depend on the information that you have available to you.

Inflation Rate Formula

The first formula we’ll look at is best if you’re looking for the inflation rate for a specific product or service over a given period of time. In order to make this work, you’ll need the average price of the product during both years as your starting and ending point.

[ (Updated Price − Original Price) ÷ Original Price] × 100

Let’s say I’m trying to find the difference between the average price of a cup of coffee in 1992 and 2012. Here are the steps:

1. Find the average price in both years: $1.60 in 1992 and $2.62 in 2012
2. Enter the data into the equation.
3. Subtract the 1992 price from the 2012 price ($1.02)
4. Divide the difference by the original price. ($1.02 ÷ $1.60 = 0.6375)
5. Multiply the previous answer by 100 to get a percentage. (0.6375 × 100 = 63.75%)

Consumer Price Index

In contrast to the above inflation rate formula, the formula the CPI uses is good for comparing goods or services in a basket for the current year to a base year in order to determine inflation. Here’s the formula:

(Current Price ÷ Base Year Price) × 100

Let’s use this formula to find the inflation rate between a base year, 2002, and now for a loaf of white bread. Here’s how it works:

1. Find the average price of a loaf of white bread in 2002 ($1.02) and July 2022 ($1.72)
2. Divide the 2022 average price by the 2002 average price (.68). Ignore the 1. That’s just there because prices have gone up. If the first number you see in your calculator is 0, it means prices have gone down relative to the base year.
3. Multiply the result by 100. (68%)

Let’s pretend for a moment that prices have gone down. Here’s how the formula would work in that case, pretending the price of bread was now $1.02 and in July 2002, the price was $1.72. Here’s the formula.

1. You would divide as normal, ($1.02 ÷ $1.72 = 0.59)
2. Multiply this by 100. (0.59 × 100 = 59%)
3. Subtract the previous result from 100 to find the percentage of deflation (100 - 59 = 41%)

In this hypothetical scenario, the price of bread has dropped 41%.

Now that you know how to calculate inflation, you may have questions as to how you’re personally affected. Here are a few common questions surrounding inflation rates.

How does the inflation rate affect my personal finances?

Inflation can affect your personal finances in several ways. Let’s run through several of them.

• Everything costs more. Unless your wages are going up regularly to keep up with inflation, this can quickly mean that you have less purchasing power. It’s worth noting that not everything increases at the same rate, so your personal inflation rate will vary. If you go to the grocery store, you’re feeling inflation, but not nearly as badly as someone who has purchased a vehicle in the last year.
• Borrowing becomes more expensive. The primary way to combat high prices is to essentially take money out of the economy. The government doesn’t reach out and take your money back. Rather, the Federal Reserve raises the federal funds rate. Because this is the rate at which banks borrow money, it affects every rate they set for consumers. There have been several fed funds rate hikes this year that have pushed up rates for everything from credit card rates to mortgages. This encourages people to save the money they have and earn slightly higher interest rather than borrowing at higher rates to support elevated spending.
• Long-term high inflation complicates retirement planning. If the inflation rate is elevated for a long period of time, it can drastically affect how long your retirement dollars last.
• It can impact investment strategy. More people may have a greater tendency to invest in stocks which have a higher risk, but greater return. This is due to the fact that although bonds may have a guaranteed return, it may not keep up with inflation.

Should I change my spending habits because of the inflation rate?

The way you react to inflation is going to depend entirely on the amount of resources you have. Those with more money will be better able to deal with drastic price increases than those who don’t have as much. However, whether you need to find places to cut back or you just want to show producers that ever-higher prices are unacceptable, here’s what you can do:

• Create or reevaluate your budget.
• Avoid or cut back on eating out and cafe coffee.
• Shop when things are on sale and use coupons. Most retailers have made them accessible on your phone now.
• Cancel unnecessary subscription services. If you watched one series last year and never went back, it’s time to say goodbye.
• Consider cheaper alternatives like store brands and staycations.

These are just suggestions and shouldn’t be taken as telling anyone what to do. If you’ve been planning that trip to Bora Bora for years, and finally have the money, feel free to get on the plane and have a good time. It’s ultimately your money to enjoy.

Can I buy a home during a period of high inflation?

When inflation is high, finding and purchasing a home can become more difficult, though certainly not impossible. The cost of buying a home rises as prices go up. Also, the cost of services associated with your transaction, like appraisals and home inspections, are likely to be higher. Finally, saving for a down payment can be harder if more of your budget is going to other areas.

In order to combat the saving problem, you may be able to look into down payment assistance. This could allow you to come in with more equity while saving upfront costs. You’re also more likely to secure a good interest rate the better your credit is.

In any case, if you see a rate you like, it’s best to lock that rate as soon as possible, especially if you’re looking to protect yourself from higher rates in a rising rate environment. Our RateShield^® program allows you to lock your rate for up to 90 days while shopping for a home. If rates fall over that time, you have a one-time option to move down to the lower rate.¹

The inflation rate is the rate at which prices increase over time. There are two formulas that you can use to calculate inflation for yourself. Which is right depends on the information you have. Inflation makes everything more expensive, including homes and mortgages. Still, there are ways to set yourself up for success with down payment assistance and a good rate.

If you’re looking to better prepare for the cost of homeownership, here’s more info on how inflation affects mortgage rates. If you think now is the time for you to move forward, you can apply online or give us a call at (833) 326-6018.

¹ RateShield Approval is a Verified Approval with an interest rate lock for up to 90 days. If rates increase, your rate will stay the same for 90 days. If rates decrease, you will be able to lower your rate one time within 90 days. Please contact your Home Loan Expert for additional information. This offer is only valid on 30-year FHA, VA and conventional purchase loan products. RateShield Approval not eligible for clients with a signed purchase agreement, on Charles Schwab loans, or new construction loans. Additional conditions and exclusions may apply.