Inflation occurs when demand exceeds supply in an economy, which causes prices to go up across all sectors. In recent months, supplies, inventory and labor costs have all been a cause for concern, which has caused challenges for small businesses in almost every sector of the economy. The consumer price index for all products went up 0.6% in January, driving up annual inflation by 7.5%. This marked the biggest gain since February 1982 — higher than the Wall Street estimate, according to a report by CNBC.
Apart from the general trend for inflation, most business owners worry about inflation due to one main reason: their own respective selling prices and costs. And rightly so! Based on recent data from the U.S. Bureau of Labor Statistics, since the beginning of 2022, more than half of small businesses have had to increase their prices, the highest percentage since 1974.
In this article, we look at four common inflation measures that business leaders need to keep an eye on.
Consumer price index
The U.S. Bureau of Labor Statistics defines CPI as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” The CPI is the most widely used and watched measure of the U.S. inflation rate. It is also used to calculate the real gross domestic product.
This inflation index is often considered controversial. One of the main reasons for the conflict is that “economists differ on how they feel inflation should be measured.” At first, the CPI was calculated by comparing the price of a fixed basket of goods and services spanning two different periods. According to Investopedia, the basket represents consumer spending patterns, and the change in its price is representative of the rate of inflation faced by consumers as a whole. For instance, if the basket’s price increases 5% in the course of the year, consumer inflation can be said to be running at an annual rate of 5%.
In reality, not everyone’s expenditure is likely to match the proportions of the CPI basket. For example, some people spend more on travel and less on clothing. Also, vegetarians do not purchase meat even though meat is part of the CPI.
However, over the years, the methodology used to calculate the CPI has undergone several modifications. According to the Bureau of Labor Statistics, the modifications removed biases that caused the CPI to overstate the inflation rate. The new approach takes into account changes in the quality of goods and substitution.
That said, the CPI represents the average. It’s common for people to focus on price tags they encounter every day, such as those on milk or gasoline. And the thousands of other prices they pay often get ignored.
Personal consumption expenditures price index
The PCE price index is another important measure that adjusts the weights continually. According to the Bureau of Economic Analysis, the PCE price index is “a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.” This is an important reason why economists prefer this approach, as it showcases a lower rate of inflation.
Both CPI and PCE price index are calculated with and without food and energy. The exclusion of these items in some indexes may give a wrong picture, because everyone buys food and energy. The reason for the exclusion is that food and energy prices vary differently from other prices. Gas prices rise and fall on the basis of oil prices, but the CPI almost always increases. Therefore, gasoline does not necessarily illustrate inflationary pressure in the economy. Similarly, crop failures can cause food prices to rise, but that is unlikely to last.
Producer price index
Another index to monitor inflation is the PPI. The PPI “measures the average change over time in the selling prices received by domestic producers for their output,” according to the U.S. Bureau of Labor Statistics.
PPI “is a measure of inflation at the wholesale level of the economy compiled from thousands of indexes measuring producer prices by industry and product category. The BLS calculates thousands of PPI indexes based on the product or service sold, the industry of the producer and the economic identity of the buyer, which are then used to calculate the overall monthly change in final demand PPI,” according to Investopedia.
Employment cost index
Labor costs are critical to most organizations. Overall labor inflation can be best calculated using the ECI. As per the U.S. Bureau of Labor Statistics, the ECI “measures the change in the cost of labor, free from the influence of employment shifts among occupations and industries.”
Even though average hourly earnings are more widely reported, the ECI changes with the composition of the labor force. For instance, during COVID-19–related lockdowns, many lower-wage employees lost their jobs. At that time, the average indicated only the higher-wage employees, suggesting a nonexistent wage acceleration. The ECI takes care of this issue by looking at wage changes for the same job. It also assesses benefits, which can move up more or less as compared to wages.
