Underlying inflation
Implicit inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers and others expect them to continue to rise at a similar rate in the future and demand higher costs or wages to maintain their standard of living. Their increased wages result in higher costs of goods and services, and this wage-price spiral continues as one factor induces another and vice versa.
Price index type
Based on the selected set of goods and services used, a basket of several types of goods is calculated and tracked as a price index. The most commonly used price indices are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
Consumer price Index
The CPI is a measure that examines the weighted average of the prices of a basket of goods and services with primary consumer needs. These include transportation, food and medical care. The CPI is calculated by taking the price changes for each item in a predetermined basket of goods and averaging them based on their relative weight across the basket. The prices in question are the retail prices of each item as available for purchase by individual citizens.
Changes in the CPI are used to estimate price changes associated with the cost of living, making it one of the most commonly used figures to identify periods of inflation or deflation. In the US, the Bureau of Labor Statistics reports the CPI on a monthly basis and is calculated as far back as 1913.
The Consumer Price Index has been revised six times. The Consumer Price Index (CPI-U) for all urban consumers, introduced in 1978, is representative of the shopping habits of approximately 80% of the non-institutionalized population of the United States.
Wholesale price index
The WPI is another popular measure of inflation, which measures and tracks changes in the price of goods from the retail level to earlier stages. While WPI items vary from country to country, they mostly include items at the manufacturer or wholesale level. For example, it includes cotton prices for raw cotton, cotton yarn, cotton brown goods and cotton fabrics.
Although many countries and organizations use the WPI, many other countries, including the US, use a similar version called the Producer Price Index (PPI).
Producer price Index
The producer price index is a family of indices that measure the average change in selling prices received by domestic producers of intermediate goods and services over time. PPI measures price changes from the seller's point of view and differs from CPI which measures price changes from the buyer's point of view.
In all such forms, it is possible that an increase in the price of one component (such as oil) cancels out a fall in the price of another (such as wheat) to a certain extent. Overall, each index represents the average weighted price change for the given components that may apply to the overall economy, sector or commodity level.
Formula for measuring inflation
The above types of price indices can be used to calculate the inflation value between two particular months (or years). While many ready-made inflation calculators are already available on various financial portals and websites, it is always better to be aware of the underlying methodology to ensure accuracy with a clear understanding of the calculations. Mathematically,
Percentage Inflation Rate = (Final CPI Index Value / Opening CPI Value)*100.
Let's say you want to know how the purchasing power of $10,000 changed between September 1975 and September 2018. One can find the price index data in a tabular form on various portals. From that table, select the respective CPI figures for the given two months. It was 54.6 (initial CPI value) for September 1975 and 252.439 (final CPI value) for September 2018. Plugging in the formula yields:
Percentage Inflation Rate = (252.439/54.6)*100 = (4.6234)*100 = 462.34%
Since you want to know how much $10,000 in September 1975 would be worth in September 2018, multiply the percentage inflation rate by the amount to get the converted dollar value:
Change in Dollar Value = 4.6234 * $10,000 = $46,234.25
This means that the price of $10,000 in September 1975 would be $46,234.25. Essentially, if you bought a basket of goods and services (as included in the CPI definition) worth $10,000 in 1975, that same basket would cost you $46,234.25 in September 2018.
Inflation pros and cons
Inflation can be thought of as a good or a bad thing, depending on which one favors, and how fast the change occurs.
For example, individuals with tangible assets denominated in currency, such as property or stocked items, may prefer to see some inflation as this increases the price of their assets, which they can sell for a higher rate. However, buyers of such a property may not be happy with inflation, as they will need to spend more money. Inflation-indexed bonds are another popular option for investors looking to benefit from inflation.
On the other hand, people holding assets denominated in currency such as cash or bonds may also not like inflation, as it destroys the true value of their holdings. Investors looking to protect their portfolio from inflation should consider inflation-protected asset classes, such as gold, commodities, and real estate investment trusts (REITs).
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