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How the Inflation Rate Preserves Economic Harmony

By Nancy Johnshoy, CFA, Market Strategist

Some people, especially those with enough gray hairs to have lived through periods of high inflation, were dismayed by the Federal Reserve’s recent announcement that it will shift from a target of 2% price inflation to a “flexible form of average inflation targeting.” In this article, we shed some light on how inflation is measured and controlled, what a desired level of inflation looks like, and what typically has caused damaging levels of inflation.

MOVIE TICKETS & INFLATION

Market Update
Source: BLS

Let’s first cover the basics. Inflation is broadly defined as a general upward trend in the overall price level for goods and services in an economy. There also can be inflation on a narrower scope – common examples include rising prices in commodities, real estate, or health care. The most commonly recognized measure is the Consumer Price Index (CPI), which the Bureau of Labor Statistics has maintained since 1919. CPI measures the change in the price of a representative basket of goods and services and can be used to measure the buying power of the dollar over a period of time. When I was a kid in the 70s, we could buy a movie ticket for 50 cents. After factoring in the cumulative inflation rate over time, that equates to a ticket price of $3.34 today. Since the average cost of a movie ticket today is around $10, movie prices have increased at a rate greater than inflation.

The broadest measure of price changes is the CPI-U, which is the CPI for “all urban consumers.” This measures the price change of a weighted basket of consumer goods and services over time. This index, introduced in 1978, represents the buying habits of approximately 80% of the U.S. population.  Because food and energy can be volatile over short periods, the “core” CPI index excludes these categories. This index was introduced in the 1970s when food and oil prices were highly volatile, and the Federal Reserve wanted an index less influenced by short-term price shocks. Other indices track goods in various stages of the production process. Producer Price Index (PPI) tracks changes in the cost of producing goods and is closely watched for early warning signs of price increases that may show up in finished goods.

THE FEDERAL RESERVE’S DUAL MANDATE

The Federal Reserve is the United States’ central bank. Created in 1913 by the Federal Reserve Act, its purpose is to provide a safer, more flexible, and stable monetary and financial system. The Federal Reserve has a dual mandate to promote both maximum employment and stable prices. These mandates are frequently referenced in its policy statements. The term “monetary policy” refers to the activities undertaken by the Federal Reserve designed to influence the availability and cost of money and credit to help promote these national economic goals.

market update
Source: Federal Reserve

In 2012, the Federal Reserve provided clarity around these objectives by designating a 2% target inflation rate and shifted to utilizing the annual change in the price index for personal consumption expenditures (PCE) as its measure of price stability. The PCE is measured and released monthly by the Bureau of Economic Analysis in its Personal Income and Outlays report. One primary difference between the commonly known CPI and the PCE Price Index is that PCE uses a formula that allows for changes in consumer-buying behavior, whereas CPI is a basket of goods that is recalculated and updated only bi-annually. The PCE calculations result in a more nuanced and sensitive measure of changes in inflation. The second goal of fostering full employment means that every American who wants to work is gainfully employed. The factors that determine maximum employment may change over time and may not be directly measurable. As a result, the Federal Reseve does not specify a fixed goal for this mandate but bases its decisions on its members’ assessments of the structure and dynamics of the job market. In the Federal Open Market Committee’s (FOMC) June 2020 Summary of Economic Projections, Committee participants’ estimates of the longer-run normal rate of unemployment ranged from 3.5 to 4.7%.

A BRIEF HISTORY OF INFLATION

My dad turned 90 last December, so in his lifetime he has experienced four periods of inflation spiking over — sometimes well over — the 10% mark. Anyone under the age of 55 probably is acquainted with high rates of inflation only from tales told by our elders about double-digit mortgage rates and escalating prices. We last saw inflation over 10% in the early 1980s, when the inflation level peaked at 14.76% in April 1980. This largely resulted from policies of the 1970s designed to promote growth without regard to the negative impact on inflation. To combat inflationary pressures, the Federal Reserve was forced to push short-term rates to a peak of 20% in June of 1981 to reverse the trend.

In the short run, inflation can be impacted by supply and demand pressures in the economy. Causes can include increases in demand due to surges in spending, or “supply shocks,” which are sometimes caused by natural disasters or unrest. An example of this are short-term inflation shocks caused by sudden spikes in the price of oil as seen during many of the periods of conflict in the Middle East.

Increased inflation over the long run is tied more closely to the growth rate of the money supply relative to the growth in the economy. This is where Federal Reserve policy comes into play. If growth is slow, the Federal Reserve can accelerate activity by easing (lowering) rates. If growth is too quick and potentially overheating, it can defer growth by tightening (raising). We often hear the phrase “the Federal Reserve is printing money.” This doesn’t actually mean it is physically cranking out new bills. Rather, using tools at its disposal, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve banks. Changes in the federal funds rate trigger a chain of events that affect other short-term and long-term interest rates, foreign exchange rates, the amount of money and credit, and a range of economic variables, including employment, economic output, and prices of goods and services. The announcement that the Fed will allow inflation to potentially drift above the 2% target rate means that it will have the flexibility to keep short-term rates lower for longer to encourage growth.

TODAY’S INFLATION OUTLOOK

This brings us full circle to the potential concern that a more relaxed approach to inflation could lead us down a path to higher systemic inflation. It is understandable that the prospect of higher prices adds to the burden many families face, especially those struggling with lost income. At the same time, inflation that is too low can weaken the economy. The goal of 2% inflation is consistent with a healthy and growing economy. For many years, inflation in the United States has run consistently below that 2% goal. If inflation expectations fall, interest rates across the yield curve decline, too. In turn, there would be less room to cut interest rates to boost employment during future economic downturns. Evidence from around the world suggests that once this problem sets in, it can be very difficult to overcome. To address this challenge, following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation modestly above 2% for some time. By seeking inflation that averages 2% over time, the Federal Reserve will help to ensure longer-run inflation expectations remain well-anchored at 2%.

As always, the investment team at First Business will monitor the inflation outlook along with the other key indicators that influence our investment strategy. I encourage you to reach out to your advisory team to discuss this further and other topics that might potentially impact you.

September 17, 2020

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