In this article, you will learn how to adjust the inflation by using CPI. Inflation adjustment or deflation is the process of removing the effect of price inflation from data. It makes sense to adjust only data that is currency denominated in this way. If you are dealing with a currency denominated time series, deflating it will extinguish the fraction of The up-down movement in it that was a consequence of general inflationary pressure.
How to Adjust the Inflation by Using CPI?
You can adjust for inflation by dividing the data by an appropriate Consumer Price Index and multiplying the result by 100.
This is an important formula. Let's tag it as Equation I. We'll need to use it again soon.
There are two things you should know while using this formula:
In the denominator of this formula, it is important to use the correct price index — there are usually several price indexes that you can choose from.
Which CPI Should You Use?
There are usually several kinds of CPI available and you should use the right kind for your category of data. For example the US Bureau of Labor Statistics (BLS) publishes a large number of price indexes. Which index you use depends on what data you wish to deflate and what property of your data you wish to measure.
Example 1: Suppose you have a time series for the average yearly apple prices found across all urban areas of the United States. If you wish to bring out the core-growth in the price of apples experienced by urban consumers in the US, after discounting the effect of the overall inflation experienced by urban consumers, you should use the CPI-All Urban Consumers: US All items, 1982–84=100 or the CPI-All Urban Consumers: US All items, 1967=100 to deflate your apple price data. If you make the mistake of using the very popular index CPI-Urban Wage Earners and Clerical Workers you will get incorrect results because this index measures the price inflation experienced by only urban wage & salary earners, not by all urban consumers.
Example 2: Say you wish to bring out the core growth in apple prices after canceling out the effect of overall urban food inflation, you should use the index CPI-All Urban Consumers: Food and beverages in US city average, all urban consumers, not seasonally adjusted to deflate your data. This will give you a measure of how much dearer or cheaper apples became wrt to other food items and only for urban consumers. I'll describe this particular use of CPI in more detail later.
Bottom Line
Examples of inflation adjustment data are weekly wages, the interest rate on your deposits, or the price of a 5 lb bag of Red Delicious apples in Seattle. This article will tell you how to adjust the inflation by using CPI.
