Meet the Author

Owen F. Humpage |

Senior Economic Advisor

Owen F. Humpage

Owen F. Humpage is a senior economic advisor specializing in international economics in the Research Department of the Federal Reserve Bank of Cleveland. His research focuses on the international aspects of central-bank policies and has appeared in the International Journal of Central Banking, the International Journal of Finance and Economics, and the Journal of Money, Credit, and Banking. Recently, Dr. Humpage co-authored a history of U.S. foreign-exchange operations.

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Meet the Author

Michael Shenk |

Research Assistant

Michael Shenk

Michael Shenk was formerly a research assistant in the Research Department of the Federal Reserve Bank of Cleveland. His work focused on international topics and housing-market indicators.

03.07.08

Economic Trends

Are We Importing Inflation?

Owen F. Humpage and Michael Shenk

Headline and core price indexes recently have been rising at a disconcertingly fast pace, reflecting the direct and secondary pass-through effects of record oil prices, rapidly rising agricultural prices, and the dollar’s depreciation.  Some observers, noting the international lineage of these price patterns, wonder if world economic development and the integration of global markets have doomed the United States to a permanently higher rate of inflation. This question reflects a very common misunderstanding of what price indexes tell us and of the true nature of inflation. To be sure, greater global claims on scarce world resources will raise our cost of living, but inflation has everywhere and always been a home-grown, central-bank problem.

January CPI Statistics

    Annualized percent change, last:
    1mo. 3mo. 6mo. 12mo. 2007 avg.
Consumer Price Index
  All items
4.8
6.8
4.7
4.4
2.9
  Less food and energy
3.8
3.1
2.7
2.5
2.3
  Median
4.2
3.7
3.4
3.2
3.1
  Trimmed mean
4.3
3.5
3.1
3.0
2.7

Source: The Bureau of Labor Statistics

Inflation refers to the deterioration in the purchasing power of money that results when a central bank creates more money than the public wants to hold. Inflation manifests itself as a rise in all prices and wages—in fact, anything denominated in dollars. If the public’s demand for money grows at 3 percent per year and if the central bank creates money at 5 percent per year, then prices will eventually rise at 2 percent per year, and they will keep climbing as long as the disparity between the supply and demand for money continues. While the rate of inflation is ultimately under the control of central banks, the speed with which an inflationary monetary impulse filters through to wages and prices seems to depend on many things, including the amount of slack in an economy, whether the public anticipated the inflation, and the degree of price competitiveness throughout the economy. When the economy is operating at full tilt, when people generally anticipate inflation, and when firms and workers operate in a highly competitive environment, monetary excesses are likely to translate quickly into higher prices and wages.

Inflation is not the only type of price pressures that an economy experiences.  Individual prices adjust continually to the ebb and flow of supply and demand pressures. Economists often refer to these as relative (or sometimes real) price adjustments. Although they hit our price indexes much like inflation, relative prices adjustments are fundamentally different. For one thing, relative price changes convey important information about the relative scarcities of goods and services. A rising relative price indicates that demand has outstripped supply (or that supply has fallen short of demand), while a falling price denotes just the opposite. Relative price changes also help stabilize the economy.  A rising relative price induces consumers to conserve on a specific good and to look for substitutes.  A rising relative price also entices producers to bring more of the good to market. Relative price changes are vital for the smooth functioning of any market economy; inflation, however, contributes no information useful to our consumption, production, and labor choices.

Import Prices

  Average annual percentage change:
2/02-1/08
CPI
3.0
Imports
  All
5.8
  Foods
6.5
  Industrial materials
17.0
  Capital goods
−0.6
  Automotive
1.0
  Consumer
0.7
  Petroleum
26.8
  Nonpetroleum
2.2

Source: The Bureau of Labor Statistics.

Export Prices

  Average annual percentage change:
2/02-1/08
CPI
3.0
Imports
  All
3.6
  Foods
10.1
  Industrial materials
9.1
  Capital goods
0.2
  Automotive
1.0
  Consumer
1.3
  Agriculture
9.9
  Nonagriculture
3.0

Source: The Bureau of Labor Statistics.

Currently, petroleum and agricultural goods are experiencing very strong upward relative price pressures. Two factors seem to account for this. First, the world has experienced what seems to be unprecedented economic performance in recent years according to IMF data.  Between 2004 and 2007, the world economy grew at an exceptionally strong 5.1 percent average annual rate, and nearly all nations have shared in this expansion.  Emerging market countries in Southeast Asia, notably China and India, have led the way. As these nations develop, they place greater demands on world food stuffs, petroleum supplies, and other resources. Also putting upward pressure on many prices has been the dollar’s depreciation. Since early 2002, the dollar has depreciated more than 25 percent on a broad, trade-weighted basis. A dollar depreciation reduces the foreign-currency prices of dollar-denominated goods and thereby shifts world demand toward those goods. Because of the dollar’s role as the key international currency, most of the world’s commodities, like oil and agricultural goods, are denominated in dollars. The prices of U.S. foods and industrial-materials exports, for example, are rising at or near double-digit levels.

Although relative price pressures can be broad based, their impact on the overall price level in an economy is by nature transitory. Petroleum and agricultural products enter the production process of a very wide range of other goods. Consequently, higher prices of these basic commodities tend to pass through into the prices of other producer and consumer goods. Nevertheless, as long as the central bank is not creating an excessive amount of money, this pass-through effect is limited. As consumers spend more money on higher-priced petroleum and agricultural goods—the quantity demand of these items seems fairly unresponsive to price changes—then they eventually must have less money to spend on other goods and services. Other relative prices must then fall, so that over the intermediate to long term, the average rate of the price rise tends to equal the underlying inflation rate as determined by monetary policy. People’s cost of living certainly will rise, their incomes will buy less, and their economic well-being will be diminished. Nevertheless, these relative price pressures do not generate inflation.

One wrinkle in this story has to do with the dollar’s depreciation. Since early 2006, the depreciation seems to reflect international portfolio diversification, rather than excessive U.S. money growth. Over the past 25 years, the U.S. has financed its current account deficits by issuing financial claims to the rest of the world. Economists have long expected that, at some point, foreign investors—both private and official—would become reluctant to hold additional dollar-denominated assets and at this point the dollar would depreciate. Of course, concerns about future inflation could motivate portfolio diversification and dollar depreciation, but to date, direct measures provide little evidence of rising inflation expectations. We are not importing inflation through the dollar’s depreciation.