Inflation, Explained: CPI, PCE and Why 2% Is the Magic Number

Foundations

Inflation is the rate at which prices in general are rising. If inflation is 3 per cent, the same basket of goods and services costs 3 per cent more than a year ago, and every pound or dollar of savings quietly buys 3 per cent less. Central banks target roughly 2 per cent: enough to grease the economy, low enough that nobody has to think about it. When inflation breaks away from target, it dominates everything else in markets.

How it is measured: CPI vs PCE

The United States publishes two headline measures. The Consumer Price Index (CPI) tracks a fixed basket of what urban households buy and is released mid-month; it is the number in news headlines. The PCE price index, published later in the month, covers a broader set of spending and allows for people switching products when prices change; it usually runs a little cooler than CPI. The Federal Reserve’s 2 per cent target is defined on PCE, which is why markets treat the PCE release with equal seriousness even though CPI gets the headlines.

Headline vs core

Each measure comes in two flavours. Headline inflation includes everything. Core inflation strips out food and energy, not because they do not matter, but because they swing with weather and geopolitics and can mask the underlying trend. Central bankers watch core to judge whether inflation is embedded in the economy; a jump in petrol prices is a shock, but rising prices across services month after month is a trend that demands higher rates. For a worked example, the June 2026 CPI report shows the gap between headline inflation at 3.5 per cent and core at 2.6 per cent, and why the difference decides policy.

Why markets trade every print

Inflation determines what central banks do with interest rates, and rates price everything. A hotter-than-expected print pushes rate expectations up, bond yields up, and usually share prices down; a cool print does the reverse. Bond investors also care directly: inflation erodes the fixed payments a bond makes, so decades of expected inflation are baked into every long-term yield. When you see the 10-year yield jump on a CPI morning, that is the market rewriting its inflation forecast in real time.