What is inflation, and why is it so important to the outlook for the economy and Federal Reserve interest-rate policy?
You’ve probably noticed that prices for some things, like college tuition, prescription drugs and the rent for an apartment, reliably go up virtually every year. Prices of other things, like basic laptop computers, televisions and not-so-fashionable apparel have tended to fall over time.
The Labor Department’s consumer price index measures the overall change in the price of goods and services based on an average person’s budget. That assumes roughly 42% spent on housing, 14% on food, 9% on health care, 6% on energy — electricity, gas and fuel for your car, and so forth.
What Is Inflation?
Inflation is a general rise in the price of goods and services that erodes the value, or purchasing power, of the dollars in your wallet and bank account. The inflation rate is the percentage increase in prices over 12 months. The 2.3% rise in the consumer price index in 2019 essentially meant that the purchasing power of $100 at the start of 2019 fell to $97.75 at the start of 2020.
Yet, prices fell at an unusual rate amid the coronavirus lockdown, especially prices of energy, transportation and apparel. In the year through October 2020, the inflation rate slipped to just 1.2%.
However, core consumer prices, which exclude more volatile food and energy prices, rose 1.6% over the past 12 months.
The CPI measures prices on the consumer level. The Labor Department’s producer price index tracks wholesale inflation based on prices paid by one business to another.
How The Fed Measures Inflation
The consumer price index is the best-known inflation measure. But the Fed prefers a somewhat different measure of prices, the Commerce Department’s personal consumption expenditures price index. The Fed’s inflation target also focuses on core prices, excluding volatile food and energy costs. In addition to prices paid directly by consumers, the PCE price index also factors in bills that are paid on behalf of consumers, such as government reimbursement of hospital bills.
The Fed’s favored core PCE price index tends to rise more slowly than the CPI. That’s partly because it has a smaller housing component. The PCE also factors in a substitution effect, meaning the tendency of consumers to minimize their exposure to price hikes. When possible, they substitute less-expensive purchases that are similar in nature. If coffee prices were to spike, people might drink more tea, for example.
Core PCE prices rose 1.55% from a year ago in the latest month. That’s well below the Federal Reserves 2% inflation target.
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What Are Inflation Causes?
Sometimes prices rise because demand exceeds supply, allowing the seller to raise prices — and profits.
Producers also may increase prices when they’re faced with cost increases of their own. For example, Chipotle Mexican Grill (CMG) said it expected to raise prices 1.7% in 2019, after a 4% hike the prior year, amid higher costs for beef and avocados.
Chipotle also hiked prices to offset higher hourly wage hikes of 4% to 5%. Wages are a major business cost and can contribute to inflation when they are increasing. Before the coronavirus pandemic, wages were growing because of state and local minimum wage hikes. And because employers had to pay more to retain and attract quality workers at a time of low unemployment.
Chipotle Price Hike Example
Chipotle’s price hike was an example of cost-push inflation. But companies often try to limit the cost increases they pass on to customers by finding ways to make their operations more efficient and their workers more productive.
A price increase will generally dampen demand somewhat. But when a price hike nevertheless boosts revenue, companies are said to have pricing power.
In robust economic times, when wages are rising nicely and people have more cash at their disposal, more companies are likely to have pricing power. That’s why the inflation rate tends to be cyclical. It rises when the economy is zipping along, and slackens when consumers become less optimistic and more tightfisted.
How Does Inflation Affect Interest Rates?
The job of the Federal Reserve is to achieve low inflation and maximum sustainable employment. In other words, the U.S. central bank is supposed to keep the jobless rate as low as possible without setting off an upsurge in inflation. The Fed has officially adopted a 2% annual inflation target, and it primarily uses interest rates to achieve its goal.
When the Fed’s key interest rate — the rate for overnight bank loans — is low, banks can offer cheaper loans to businesses and consumers, helping the economy grow. By hiking its key rate, as it did nine times from 2015 through 2018, the Fed restrains growth by raising borrowing costs.
Why would the Fed want to slow growth? After all, inflation has been tame for the past couple of decades, and most people expect it to remain that way. Mainly, policymakers worry about the economy overheating. Inflation is just one of the symptoms that reveal excesses building up in the economy. Such excesses can turn a boom into a recession, like happened with the Dot-Com and housing bubbles.
A Little Inflation Seen As Healthy
A little inflation is seen as healthy, but its costs begin to mount as inflation heads higher. When the value of money erodes at a faster pace, lenders are getting paid back in cheaper dollars. So they must charge higher interest rates to compensate for inflation, as well as for the risk of nonpayment. Retirees and those nearing retirement who have much of their savings in bonds that aren’t protected for inflation are at risk of seeing the value of their savings shrink when inflation gathers steam.
But the Fed worries even more about deflation, an outright decline in prices. Falling prices make it harder for debtors to repay loans. If prices are falling, consumers also may put off purchases to wait for still-lower prices.
The Fed has lots of experience and success fighting inflation with interest-rate hikes. But fighting deflation requires different kinds of tools because the Fed has never dropped its benchmark interest rate below zero.
Fed Shift In Monetary Policy Reflects Low Inflation
After the Federal Reserve hiked its key interest rate to a range of 2.25%-2.5% in December 2018, and signaled a couple of more hikes to come in 2019, the stock market dived, prompting a Fed rethink.
By August 2019, the Fed had begun cutting its benchmark overnight lending rate, making quarter-point rate cuts in August, September and October. What prompted the Fed change? Despite some headwinds related to the on-again, off-again China trade war, the economy was doing pretty well by most measures.
The unemployment rate, at 3.7%, wasn’t far above a 50-year low. Previously, when unemployment fell that low, the Fed braced for an uptick in inflation and often acted preemptively to avoid it by hiking its key interest rate. That’s more or less what happened in 2018.
Major Shift In 2019
Yet in 2019, the Fed’s key gauge of inflation surprised policymakers. Instead of rising inflation due to a tight labor market, inflation pressures eased somewhat. Policymakers grew concerned that inflation appeared stuck below their 2% target. In an effort to anchor inflation expectations near 2%, and to lessen the risk of deflation, the Fed decided it needed to get inflation above 2% for a while.
All that happened before the pandemic, which forced the Fed to keep cutting its benchmark rate almost all the way to zero. In August 2020, the Fed explicitly altered its thinking about the connection between inflation and low unemployment. Policymakers said they will no longer assume that a tight job market will fuel inflation. Further, the Fed signaled it would hold off on any rate hikes until inflation gets close to 2.5%. That might take several years.
That’s a big deal. It means that mortgage rates and auto loans will be cheaper for longer. Without a Fed trying to preempt an overheating of the economy, more people will get jobs and wages will likely rise somewhat faster.
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