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What is the Inflation Index?

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  • Written By: Geri Terzo
  • Edited By: A. Joseph
  • Last Modified Date: 02 December 2016
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Inflation represents increases in the cost for goods and services in a region over time. The bigger the rise in inflation, the less that can be bought for the same amount of a region's currency. There are certain economic conditions that trigger changes in inflation, and an inflation index is designed to measure those directional changes.

It is possible to measure the speed at which the level of inflation is rising. A rate of inflation is calculated as a percentage difference in the cost for particular goods or service between two dates. For instance, if a supermarket is selling a loaf of bread for $3.50 US Dollars (USD) on Tuesday, and the same product sells for $3.75 USD by Saturday, the rate of inflation for bread over four days is 7.1 percent.

In the United States, the consumer price index (CPI) is a regional measure of consumer inflation. The CPI is an inflation index that measures the average change in prices in urban areas over a period of time. Urban neighborhoods comprise the largest percentage of the U.S. population, and this is why the CPI is calculated based on price changes in these areas. The data is calculated by the U.S. Department of Labor and the Bureau of Labor Statistics.

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Another type of inflation index is an inflation-linked bond. Bonds are considered largely safe investments because they are income instruments; that is, they routinely pay interest distributions to investors over the term of the contract. Inflation index bonds are among the safest and most reliable bond investments. That is because these investments experience low volatility and are protected from high inflation.

A bond inflation index is designed to reflect inflation in a region. When inflation rises, the price or face value of the bond rises. If the inflationary environment is a declining trend, the face value of the bond also declines. Incidentally, the price of more traditional bonds tends to rise when inflation is moderate, which makes inflation bonds look less attractive in this environment. On the other hand, inflation bond indexes tend to generate solid returns as inflation rises. Regional governments and some corporations are the most likely to issue inflation-linked bonds into the debt capital markets.

Interest rates are another measure of inflation. When a monetary policy committee in a region makes changes to interest rates, it often is done in an attempt to control inflation in one direction or another. There are two types of interest rates, including real and nominal rates. A real interest rate factors in the effects of inflation, but a nominal interest rate has not been adjusted for inflation. Economists sometimes rely on a complex mathematical calculation known as the Fisher equation to forecast nominal and real interest rate patterns.

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