What Is Inflation?

What does inflation actually mean?

Inflation is a general increase in the overall price level of goods and services in an economy over time.^[1] A rise in the cost of one product, or even several, is not enough to measure it.^[1]

The result is that money buys less: the European Central Bank (ECB) says a person can buy less for €1 today than yesterday, so the currency loses value over time.^[6] An International Monetary Fund (IMF) explainer adds that households are worse off when their income does not rise as much as prices, because they can afford to buy less.^[5] Inflation is expressed as a rate that shows how much more expensive a set of goods and services has become over a period, most commonly a year.^[5]

How is inflation measured with the CPI and PCE?

Inflation is measured with a price index, which tracks changes in the price of a group of goods and services.^[1] The U.S. Bureau of Labor Statistics (BLS) calls its Consumer Price Index (CPI) the most widely used measure of inflation.^[2] The CPI follows the average change over time in the prices consumers pay for a representative basket of goods and services.^[2]

The basket is built from records of what families and individuals actually bought.^[2] The BLS sorts those purchases into more than 200 categories within eight major groups, and it records the prices of about 80,000 items each month.^[2]

Price changes are weighted by how much people spend on each item, so products that take up more of the budget move the index more.^[2][6] The chart shows the weight of each major group in the CPI for all urban consumers (CPI-U) in December 2025.^[2][3] Housing was the largest at 44.469 percent, followed by transportation at 16.316 percent and food and beverages at 14.539 percent.^[3]

• Housing44.47
• Transportation16.32
• Food and beverages14.54
• Medical care8.42
• Education and communication5.85
• Recreation5.14
• Other goods and services2.9
• Apparel2.37

Source: U.S. Bureau of Labor Statistics [3]

The inflation rate is the percentage change in the index: in the IMF's example, a rise from 100 in the base year to 110 means inflation of 10 percent over that period.^[5]

The CPI is not the only measure: the Bureau of Economic Analysis publishes the personal consumption expenditures (PCE) price index each month, which reflects the prices people living in the United States pay for goods and services.^[4] The Federal Reserve's Federal Open Market Committee (FOMC) uses the PCE index largely because it covers a wide range of household spending.^[1]

What causes inflation?

The IMF explainer points to pressures on both the demand side and the supply side of the economy.^[5] When an increase in demand exceeds what an economy is able to produce, the strain on resources shows up as "demand-pull" inflation.^[5] The Federal Reserve describes a similar chain: when borrowing gets cheaper, households and businesses spend more, and the stronger demand may push wages and other costs higher.^[8]

On the supply side, shocks that disrupt production, such as natural disasters, or raise production costs, such as high oil prices, can reduce overall supply and lead to "cost-push" inflation.^[5]

Expectations matter as well: if people or firms anticipate higher prices, they build that into wage negotiations and contracts such as automatic rent increases, which partly determines later inflation.^[5] The IMF explainer also links long-lasting episodes of high inflation to lax monetary policy, in which the money supply grows too big relative to the size of the economy.^[5]

Why do central banks target 2 percent inflation instead of zero?

The FOMC has affirmed that inflation of 2 percent a year, measured by the PCE price index, best fits the Federal Reserve's mandate of maximum employment and price stability over the longer run.^[1] The ECB aims for 2% over the medium term, and the Bank of England works toward a 2% target set by the UK government.^[6][7]

The Fed says that when households and businesses can reasonably expect inflation to stay low and stable, they can make sound decisions about saving, borrowing and investment.^[1] The Bank of England addresses why the goal is not zero: at 2%, price rises stay small, yet the rate is high enough to steer clear of deflation.^[7] According to the IMF explainer, most economists now believe that low, stable and predictable inflation is good for an economy.^[5]

Low inflation still adds up: the ECB notes that at an annual rate of 2%, the general price level rises by more than 20% after 10 years.^[6]

How do interest rates bring inflation down?

Interest rates are the main tool.^[7][8] The Fed's primary tool is the federal funds rate, the rate banks pay for overnight borrowing, and changes in it influence other interest rates and borrowing costs for households and businesses.^[8]

The Bank of England explains the link: higher interest rates make borrowing more expensive and encourage saving, so people tend to spend less and prices tend to rise more slowly.^[7] The IMF explainer says raising rates is the usual response when an economy has overheated, but such policies may not help when inflation is driven by global rather than domestic developments.^[5] The Fed adds that the links between monetary policy and inflation are not direct or immediate.^[8]

What are deflation and hyperinflation?

Deflation is a fall in overall prices.^[5][7] The IMF explainer says that when prices are falling, consumers delay purchases in anticipation of lower prices, which means less economic activity and lower economic growth.^[5] The Bank of England adds that businesses make less money and start cutting wages and staff, which can lead to lower incomes and more unemployment.^[7]

Hyperinflation is the opposite extreme, which the IMF explainer describes as inflation of 1,000 percent or more a year.^[5] Both the IMF and the Bank of England use Zimbabwe as the example, with different figures: the IMF cites estimated annual inflation of 500 billion percent at one point in 2008, while the Bank of England says price levels rose by about 80 billion per cent in a month during 2007-2009.^[5][7] The IMF notes that Zimbabwe gave up its national currency.^[5]