There's been a lot of talk about inflation lately. While inflation, at its most basic, is an increase in prices, there are differences in the way that it is measured. You should pay attention to inflation, since it represents an erosion of your buying power.
However, it does help to know how policymakers view inflation. It will give you a better idea of how to plan your finances more effectively. Two measures of inflation that you should pay attention are CPI and core inflation.
The measure that is most often used to measure inflation in terms of consumers is the consumer price index (CPI). Tens of thousands of items, in several categories, are tracked. The basket of products of services is considered each month, and economists and statisticians look for trends. If the CPI rises, it is an indication that prices could be trending higher, with inflation on the rise.
There is some controversy surrounding the use of CPI as a reliable measure of the real inflation rate. However, there might be even more controversy surrounding the use of core inflation in setting monetary policy. The Federal Reserve, when it sets its benchmark interest rate and makes monetary and economic policy, considers the effects of inflation. While members of the Fed might consider CPI, core inflation is more frequently mentioned in policy announcements.
Core inflation is basically CPI, but with the most volatile items broken out. Core inflation doesn't include food and energy prices. As a result, some argue that the use of core inflation actually hurts more than it helps, since rising food and energy prices are more likely to significantly impact the household budgets of most consumers. You probably already know that food and energy prices often rise faster than other items — and they are prices likely to significantly impact your pocketbook.
Tracking Your Own Inflation Trends
Instead of relying on the government to tell you what's happening with inflation, you can actually track inflation on your own. Take a look at what you normally spend money on. Choose a certain day each month to check the prices of these items and create your own measure. You can watch your personal inflation index for trends in prices. If you use public transportation, gas prices aren't going to figure heavily into your personal inflation measure. If you have a newborn, and need to buy diapers, that measure will be an important part of your personal inflation measure.
You can compare your personal inflation measure to CPI and to core inflation. This will give you an idea of how accurate — how “real” — the wider statistics are for you. As you plan your finances, remember to consider the effect that inflation will have. The inflation rate will erode your returns. If you're earning 6% annually, but prices rise at 3% a year, you are only earning 4%. If your portfolio earns less than the rate of inflation, you are actually losing money in real terms.
Whether you follow CPI, core inflation or use your own measure, you should pay attention to inflation. This will allow you to make decisions about what investments will help you beat inflation.