What causes inflation? Definition, causes and how inflation is measured

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Inflation is a general rise in prices over time, and it has a few main causes: demand growing faster than the economy can produce, rising production costs such as energy, and expectations that lead people and firms to build future price rises into wages and contracts. When several of these hit at once, as they did after 2020, inflation can climb fast: US consumer prices rose 9.1% in the 12 months to June 2022, the largest increase since 1981.

Over longer periods, economists also link inflation to money growing faster than the economy. This page explains each cause, how inflation is measured in the US and UK, and why central banks aim for 2% rather than zero.

What is inflation?

The Federal Reserve defines inflation as "the increase in the prices of goods and services over time." It stresses that inflation refers to the broad economy, not the price of a single item. The Bank of England puts it in one line: "Inflation is when prices rise and how quickly they do so is called the rate of inflation." The IMF's Back to Basics series adds the time frame: inflation is the rate of increase in prices over a period, "most commonly measured over a year."

So an inflation rate of 3% means that, on average, the goods and services in the measured basket cost 3% more than a year earlier. It does not mean every price rose 3%. Some rise much faster, some fall. A lower inflation rate means prices are rising more slowly; they are still rising. Prices falling across the board has a different name, deflation.

What causes inflation?

The IMF article by Ceyda Oner groups the causes in a way most central banks would recognize. They are set out below, with the 2020s as a reference point.

Demand-pull inflation

Demand-pull inflation happens when spending in the economy grows faster than what firms can produce. The IMF describes it as what happens when "demand exceeds production capacity": with more money chasing the same goods and services, sellers can raise prices.

The pandemic gave a clear example. The Bank of England, explaining why UK prices rose, points to "a surge in demand for products after the Covid lockdowns came to an end," adding that "businesses had problems meeting that sudden demand."

Cost-push inflation

Cost-push inflation starts on the supply side. When it becomes more expensive to make or deliver things, firms pass part of the cost on to customers. The IMF notes that supply shocks that disrupt production or raise production costs "can produce 'cost-push' inflation." Energy is the classic case, because it feeds into almost everything: transport, heating, food production, manufacturing.

The Bank of England names one of the main causes of the UK's recent inflation as "the sharp rise in the cost of energy and some food products that was caused by Russia's invasion of Ukraine." In the US, BLS reported that energy prices rose 41.6% in the year to June 2022 and food prices 10.4%. Bottlenecks in shipping and parts did the same for goods, as our page on the supply chain crisis shows.

Expectations and wages

The third cause is about expectations. If people and firms expect prices to keep rising, they act on it. In the IMF's words: "If people or firms anticipate higher prices, they build expectations into wages and contractual price adjustments, making expectations partly self-fulfilling." Workers ask for raises to keep up and firms raise prices to cover higher wages, so price rises can continue after the original shock has passed.

Money and interest rates

Over long periods, prices also depend on how much money is in the economy relative to what it produces. The IMF summarizes the quantity theory of money: "if the money supply grows too big relative to the size of an economy, the currency's purchasing power falls." In practice, modern central banks steer this through interest rates. The Bank of England explains that "lower interest rates mean it is cheaper to borrow money and there is less of an incentive to save. This encourages people to spend and increases the rate of inflation." Higher rates do the reverse.

In March 2020 both the Fed and the Bank of England cut rates to emergency lows, and both kept them there until inflation had already risen, as the rates chart further down shows.

How is inflation measured?

In the US, the main headline measure is the Consumer Price Index (CPI) from the Bureau of Labor Statistics. BLS describes it as "a measure of the average change over time in the prices paid by consumers for a representative basket of consumer goods and services." The details:

• Coverage. The most quoted version, the CPI-U, covers urban consumers, who make up over 90% of the US population.
• Prices. BLS records the prices of about 80,000 items each month, a scientifically selected sample of what consumers pay for goods and services.
• Weights. How much each item counts depends on what households actually spend, taken from the Consumer Expenditure Surveys.
• Timing. The national CPI is published monthly. The inflation rate in the news is usually the change over the past 12 months.

Analysts also watch core inflation, which leaves out food and energy. The Fed explains that these prices swing a lot and the swings often do not last, so excluding them helps show the underlying trend.

The CPI also counts smaller packages at the same price as price increases, by tracking the price per unit. Our page on shrinkflation explains how.

In the UK, the Office for National Statistics compiles the Consumer Prices Index from a basket of about 700 items, from bread and bus tickets to cars and holidays, according to the Bank of England. The annual inflation rate compares the index with the same month a year earlier.

What is the difference between CPI and PCE?

The Federal Reserve's 2% goal is set on a different measure: the price index for personal consumption expenditures (PCE), published by the Bureau of Economic Analysis. The Fed says its policy committee considers the PCE index the measure most consistent over the longer run with the Federal Reserve's mandate, and its goal is "an annual increase in inflation of 2 percent." It still looks at several indexes, because they track different products and are calculated differently.

A 2007 BEA paper by Clinton McCully, Brian Moyer and Kenneth Stewart compared the two and found that from 2002 to mid-2007 the CPI-U rose 0.4 percentage points a year faster than the PCE index. They traced the gap to three effects:

• Formula. The CPI uses a fixed-basket (Laspeyres) formula; the PCE index uses a Fisher-Ideal formula. This explained almost half of the gap.
• Weights. The two give different importance to the same items, mainly rent of shelter.
• Scope. Some items are in one index and not the other. These differences partly offset the weight effect.

Over the years the paper studied, the net result was a PCE index running below the CPI.

Why do central banks target 2% inflation?

The UK government sets the Bank of England a 2% target for CPI inflation. The Bank explains that 2% is "low enough to keep price rises small but high enough to avoid the problem of deflation," when prices fall, businesses earn less and cut wages and staff. The Federal Reserve's 2% goal, measured on the PCE index, is tied to its mandate of maximum employment and stable prices.

What happened to inflation from 2020 to 2026?

The period after 2020 combined all four causes: pent-up demand and fiscal support, supply bottlenecks, the energy shock of 2022 and, as inflation stayed high, concern about expectations. The table shows the path on official data.

The US peak of 9.1% is the BLS figure, not seasonally adjusted; the other US figures are year-over-year changes in the seasonally adjusted index on FRED. Even after inflation fell, the price level stayed higher: the US CPI index was 28.9% above its February 2020 level in August 2026. Our page on inflation after COVID sets out what the Fed, the BIS and the Bank of England concluded about the causes, and the UK household side is covered in the cost of living crisis.

How do central banks bring inflation down?

Mainly by raising interest rates. The Bank of England explains that higher rates make borrowing more expensive and saving more attractive, so people spend less, and "when overall spending in the economy falls, price rises slow down." Higher rates can also strengthen the currency, which "will tend to push down the prices of goods that businesses import from abroad."

After 2021 both banks raised rates sharply and later began to cut. The dates and levels are set out in our page on inflation after COVID.

Rate rises work with a delay and can slow the whole economy. When high inflation comes together with weak growth and rising unemployment, the result is stagflation.

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