Inflation
inflation is a sustained increase in the general price level of goods and services in an economy over time. This rise in prices reduces the purchasing power of money—meaning each unit of currency buys fewer goods and services than before.
Economists commonly measure it using indexes like the Consumer Price Index (CPI), which tracks changes in the cost of a basket of consumer goods and services, or the Personal Consumption Expenditures (PCE) price index, preferred by bodies like the U.S. Federal Reserve.
Example: the cost of a gallon of milk in the U.S. was about $0.36 in 1913, but by 2013 it had jumped to around $3.53—nearly 10 times higher—due to gradual inflation over decades.
Below is an illustration of the CPI basket
Each of the slices is further subdivided into various individual items and smaller baskets
The trick with CPI
Inflation, as measured by CPI, is often treated as a straightforward statistic. In reality, it rests on assumptions that can meaningfully affect what the number does—and does not—capture. One of the biggest sources of confusion is the CPI “basket of goods,” which is not fixed over time.
On the surface, updating the basket makes sense. Consumer spending patterns change as technology and lifestyles change. Fifty years ago, electronics were a negligible part of household budgets; today, smartphones, data plans, and computers are essential. Updating the basket to reflect this kind of structural change is reasonable.
The problem arises when the basket changes because of inflation itself, rather than independent changes in preferences. When prices rise sharply, consumers often substitute cheaper alternatives—not because they prefer them, but because they are forced to. If the CPI then reduces the weight of the expensive item and increases the weight of the substitute, the measured inflation rate can understate the true increase in the cost of maintaining a given standard of living.
A simplified example illustrates the issue.
1980
- Beef: $10 per pound, 2% of CPI basket
- Chicken: $5 per pound, 0.5% of CPI basket
2010
- Beef: $50 per pound (+400%)
- Chicken: $10 per pound (+100%)
Basket weights shift:
- Beef: 0.5%
- Chicken: 2%
In this scenario, beef becomes dramatically more expensive, so consumers buy less of it and more chicken instead. The CPI reflects this by reducing beef’s weight and increasing chicken’s. As a result, the item with the largest price increase now matters less in the index, while the cheaper substitute matters more.
Numerically, this matters. In 1980, a 10% increase in beef prices would noticeably move CPI because beef had a 2% weight. In 2010, even a 50% increase in beef prices barely registers because its weight has fallen to 0.5%. The price pressure hasn’t disappeared—households are simply responding to it by downgrading consumption.
This substitution effect doesn’t make CPI “wrong,” but it does mean CPI measures something very specific: the cost of a changing consumption basket, not the cost of maintaining the same lifestyle over time. For households that feel they are paying much more while being told inflation is “moderate,” this gap is often the reason.
“In short, CPI is best understood not as a pure measure of price increases, but as a model-based estimate shaped by behavioral assumptions—assumptions that tend to smooth inflation precisely when prices become most painful.”
Other ways to measure inflation
Another way to measure inflation is the CPI-U, which is based on a fixed basket of goods from a base expenditure period—a so-called “cost-of-goods” or pure fixed-basket index. There are many other approaches as well, each with its own trade-offs. Inflation measurement is not black and white, and it’s extremely difficult to pin down a single, definitive “inflation” number. Financial institutions understand this complexity and often use it to their advantage.
In my opinion, the most meaningful way to measure inflation is through your own spending and lived experience. If most of your money goes toward electronics, food, and rent or housing, then those categories should be your primary inflation metrics. For example, if the prices of those things are up 50% since you started tracking them five years ago—or 10% over the past year—then that’s your personal inflation rate.
National or global inflation figures don’t matter much for your small savings in practice. What matters is what you actually spend money on, and what you expect to spend on in the near future. If prices in a category are rising, you may want to buy sooner. If prices are falling—deflation—you might choose to wait and save longer. Spending and saving should adjust accordingly.
If you’re running a major bank like JPMorgan, managing a private equity firm, or have a couple million sitting in the bank, then CPI numbers absolutely matter. But if that’s the case, you’re probably not getting your advice from this article.