Why Inflation Is Very Low, and Why It Matters

Very low inflation: A recent phenomenon

Inflation then

Our last big battle with inflation began in the 1960s (figure 1). Prices began to rise steadily in the United States during that decade, and high inflation rates became a hallmark of the 1970s. During the 1970s and early 1980s, inflation twice shot above 10 percent—higher than it had been since the 1940s.

During the 1970s and early 1980s, inflation twice shot above 10 percent

Then–Federal Reserve Chairman Paul Volcker has been credited with bringing inflation back down in the early 1980s by aggressively tightening monetary policy. Even with this shift in policy, however, sustained low inflation rates did not become the norm until the mid-1990s. Between 1995 and 2008, the FOMC succeeded in keeping inflation generally low; PCE inflation averaged just above 2 percent over this time.

This is not to say that inflation was completely conquered. Even as recently as 2008, FOMC members were concerned about the possibility of re-living the inflation patterns of the 1960s and 1970s. Memories of high inflation have a long life.

High inflation rates are problematic for an economy because they create distortions that hamper economic performance. For example, firms must constantly raise prices to keep up, and consumers waste their time shopping for bargains and protecting their financial assets from rising prices. Because of these distortions, it is clear why neither the public nor central banks are keen on high inflation.

Another problem with high inflation is that it is costly to get inflation rates back down once they’re too high. Though Volcker’s shift in monetary policy successfully broke the back of high inflation, for example, the cost was a deep recession.

Inflation now

Since the most recent financial crisis, the story has been different. While inflation typically falls in the immediate aftermath of a recession, it usually rises during the ensuing economic recovery (figure 1). This time around, inflation has remained at very low levels for much of the past five years. Despite a short-lived surge of inflation in 2011, disinflation—when inflation decelerates—occurred again in 2012 and 2013.

PCE inflation—the FOMC’s single preferred measure—fell from 2.5 percent in January 2012 to only 1.1 percent in December 2013.

The falloff in inflation is evident in essentially the entire set of consumer price measures that policymakers find helpful in assessing inflation trends. PCE inflation—the FOMC’s single preferred measure—fell from 2.5 percent in January 2012 to only 1.1 percent in December 2013. Some of this deceleration in PCE inflation has been driven by energy prices. However, measures of the underlying inflation trend that are less affected by energy prices—like the core PCE or the trimmed-mean PCE—have also slowed significantly. Core PCE inflation, which excludes the short-term volatility that can come from food and energy prices, declined from 2.0 percent to 1.2 percent over the same period. Trimmed-mean PCE inflation, which excludes the most extreme monthly price changes, experienced a similar decline (figure 2).

Disinflation is also visible in the more familiar inflation measures based on the consumer price index (CPI). CPI inflation typically runs about a half percentage point higher than the PCE inflation rate. In other words, for PCE inflation to be at 2 percent, CPI inflation would typically need to run about 2.5 percent. CPI inflation fell sharply over the course of 2012 and 2013, as did core CPI inflation—which, like the core PCE measure, excludes food and energy prices. The Cleveland Fed’s 16 percent trimmed-mean inflation series declined by a similar amount (figure 3).

One measure of the inflation trend that has remained relatively stable is the Cleveland Fed’s median CPI (figure 4). Year-over-year inflation in the median CPI edged down from 2.2 percent at the start of 2012 to 2.1 percent at the end of 2013.

In general, the median CPI tends to be a useful tool for predicting future inflation trends, so its recent level suggests that CPI inflation should rise closer to 2 percent. But the median CPI may be misleading right now. Much of the stability of median CPI inflation reflects a balance between two divergent trends: first, an acceleration in the biggest component of shelter costs, owners’ equivalent rent (OER), which is very often the component in the middle of the CPI; and second, broad disinflation among other components. Recalculating the median inflation rate without the OER component reveals a sharp slowing of underlying inflation from early 2012 to the end of 2013 that is much more in line with the other measures of inflation.

On the surface, very low inflation sounds like a good thing. If inflation is running at very low levels, then the purchasing power of a dollar is not diminished over time by significant increases in prices. But very low inflation is not always good. For one thing, it can be a sign that the economy is performing under its potential—and in fact, low inflation may actually be a contributing factor in the underperformance. For another, it raises the risk that the economy could fall into deflation. Deflation—where the general price level falls—causes similar problems as inflation in that businesses and consumers waste time and energy trying to work around its consequences. Some analysts view Japan’s long period of near-zero inflation and very low economic growth as a vivid cautionary example of the dangers of extremely low inflation sustained over a long period of time.