You asked, researchers answer: Inflation Q&A
Higher inflation is on people’s minds, so we tackle a handful of questions posed online and during a recent inflation event.
Higher inflation: Temporary or here to stay?
Inflation has been rising, and some people think that higher inflation may be here to stay. We don’t think that’s the case. Predicting inflation is not a perfect science, so no one can know for sure what will happen in the future, but we think there are several reasons to believe higher inflation will not last.
One reason has to do with how inflation is measured. The rate of inflation is typically calculated over a 12-month period. That means that changes in prices that happened many months ago will still be affecting today’s rate of inflation. Twelve months ago, prices were much lower because of the pandemic than they otherwise probably would have been. So when you compare today’s prices, which are being affected much less by lockdowns and social distancing, to what prices were doing in the early phases of the pandemic, you see a big jump in prices. (Economists refer to this type of boost (or decline) in inflation as “base effects.”) But when the 12-month window of comparison moves ahead to the point that it no longer includes those abnormally low prices, the base effects will disappear and the inflation rate should move down.
A second consideration is that the high inflation readings we have been seeing lately have largely been driven by a small number of components; the price increases are not broad-based. Some of the items driving the high inflation readings include the prices of used and new cars, whose unusual jumps have been related to supply-chain issues such as the significant disruption in the supply of semiconductor chips. These bottlenecks should eventually disappear. Throughout the country, many cars sit unsold, lacking only the necessary computer chips.
The prices of some other items, such as airline fares, lodging, and gasoline, are more a sign of the economy’s normalizing than a longstanding trend in inflation. We can see that the price increases are not broad-based by looking at measures of inflation that exclude extreme price movements and focus on price movements more toward the center of the distribution of price changes—such as the Cleveland Fed’s median CPI (Consumer Price Index), trimmed-mean CPI, and median PCE (Personal Consumption Expenditures Price Index) inflation rates. These inflation rates show much less inflationary pressure than the inflation rates calculated using total prices (“headline” CPI and PCE) and the “core” inflation rates, which only exclude food and energy prices.
A third factor worth mentioning has to do with inflation expectations—what consumers, businesses, and financial markets think inflation will be in the future. Longer-run inflation expectations actually exert an important influence on inflation because they influence people’s current behavior. Measures of longer-run inflation expectations, including this data series produced at the Cleveland Fed, have remained relatively stable and have not risen in response to the incoming inflation data.
A final factor that is likely to bring inflation readings down eventually is the labor market. While the labor market has experienced a strong recovery thus far, it still has room to improve. As more people return to the workforce, it should be easier for companies to meet the demand for goods and services, and conditions in the broader economy should improve as a result. In particular, several indicators suggest that labor supply could continue to increase as COVID-related health concerns subside, childcare responsibilities ease with the return of in-person schooling this fall, and expanded unemployment insurance benefits are ended.
All of these considerations suggest to us that the high inflation readings we are seeing of late will not last.
Why are you so sure inflation won’t get out of control like in the 1970s?
There are several reasons why the inflation outlook does not suggest a return to the 1970s. First, and perhaps most importantly, are the lessons learned from the 1970s. Policymakers have a much greater appreciation and understanding of the role that expectations play in the inflation process. Economic decisions not only depend on past and current events but also on what is expected to happen in the future. If individuals expect higher inflation and act on those expectations, then those actions will influence current inflation and cause it to rise. For example, higher expected inflation can lead workers to ask for higher wages and firms to raise prices today. During the 1970s, inflation expectations began to rise steadily and coincided with high inflation readings that lasted throughout the decade. Policymakers are now more careful to monitor inflation expectations through surveys and financial market data for evidence that they may be rising in an unwelcome manner.
In addition, policymakers are aware of the benefits of improved communication and enhanced transparency for the efficacy of policy, and consequently they direct considerable effort toward keeping the public and financial markets informed of their thinking about economic developments. In terms of the current environment, the recent high inflation readings are being driven by a relatively small number of items that reflect known supply constraints or the effects of reopening the economy—factors that are unlikely to be repeated over and over and which would push up inflation rates on a sustained basis. While these large price increases are expected either to be reversed or not to be sustained, they will contribute to higher inflation readings in the near term.
Lastly, the structure of the US economy has changed markedly from the 1970s. For example, the reduced presence of labor unions and cost-of-living-adjustment clauses in labor contracts means that the effects of shocks hitting the economy are not as easily transmitted to inflation or as long-lasting as before.
If employers are raising wages to attract scarce job applicants as well as to keep recently hired employees, won’t that pressure businesses to raise their prices, leading to higher inflation?
While wage costs can influence inflation, the linkage is not necessarily as direct as the conventional narrative might suggest. There are several sources for “slippages” that loosen the relationship between wages and prices. For example, if firms are facing higher wage costs, then they may accept lower profit margins for a time instead of raising prices. It is also important to recognize the role that productivity plays in this type of discussion. Specifically, wage increases do not generate inflationary pressures if they are offset by increases in productivity. That is, if an increase in wages is accompanied by higher levels of productivity, then a firm won’t need to raise its prices.
Also, there are arguments that some of the current wage pressures may be COVID-related and reflect a decrease in the supply of labor due to health concerns, childcare responsibilities, and expanded unemployment insurance benefits. As the pandemic subsides, these factors should ease and lead to an increase in the supply of labor that will help to bring the labor market into balance, without translating into higher sustained rates of inflation.
In focusing on core inflation, which excludes the prices of energy and food, is the Fed ignoring the prices of things that affect people the most?
Policymakers at the Federal Reserve actually consider many measures of inflation when they are assessing the inflation picture because different measures supply different kinds of information. For example, there are measures for different stages of production that track inflation for raw materials (such as crude oil and coal), intermediate products (such as wood and steel), and final goods to gauge “pipeline” pressures. On the international front, there are measures that monitor changes in the prices of imports and exports. So when thinking about measures of core inflation, it is important to understand what information they are designed to provide to policymakers.
Energy and food are typically associated with highly volatile prices, and this volatility can mask the longer-run trend in inflation—the inflation rate that is expected to persist going forward. For policymakers, it is especially important to filter out the parts of current inflation readings that are unlikely to persist to assess where inflation will be in the future. This is because monetary policy affects inflation with lags, requiring decisions to be based on an understanding of where inflation will be at the time that current actions eventually take effect. For example, if current inflation is elevated but is expected to move lower, then no policy action may be needed. On the other hand, if current inflation is expected to remain elevated, then policy may need to respond to move inflation lower. The previous scenarios illustrate the benefit to policymakers of “looking through” current inflation to focus on its longer-run trend. One way of doing this is by excluding items with volatile prices such as food and energy.
Another way to think about core inflation is to see the measure as a “means to an end.” The end in question is the Federal Reserve’s 2 percent inflation objective, which is based on the all-items Personal Consumption Expenditures (PCE) index. This index is a measure that broadly captures the prices that consumers pay for the goods and services they buy and the prices of goods and services that are purchased on behalf of households (for example, medical care paid for by employers through employer-provided health insurance or paid for by governments through programs such as Medicare and Medicaid). Core inflation provides policymakers with a “means” to achieving the end in that it gives them a clearer signal of where the inflation measure of interest for policy—the all-items PCE—is heading. The fact that measures of core inflation exclude certain prices reflects policymakers’ need to see the signal, not their lack of concern or interest in particular prices.
We summarize a number of alternative inflation measures in the Consumer Price Data section of our Inflation 101 website.
Can you explain the benefit of allowing for an inflation overshoot above 2 percent in order to average 2 percent over a given time? In other words, why is averaging 2 percent “good” or “better” than always trying to hit a 2 percent target and possibly undershooting it as has happened for the better part of the last decade?
The benefit of the overshoot has to do with inflation expectations, which are an extremely important determinant of inflation. While the Federal Reserve’s target rate for inflation is 2 percent, achieving the target depends partly on keeping inflation expectations anchored at 2 percent. Two considerations underlie the Fed’s decision to achieve the 2 percent target on average over time, allowing for the possible overshoot during some periods.
One consideration is that, for most of the past 12 years, inflation has remained below the Federal Reserve’s 2 percent target. An important concern with this situation is that persistently lower-than-target inflation outcomes could lower inflation expectations (again, what consumers, businesses, and financial markets think inflation will be in the future), and these lower inflation expectations could reinforce the low inflation outcomes, thereby making it more difficult for the Fed to attain its inflation target on a regular basis.
A second consideration is that if inflation runs below the Fed’s target rate during recessions and rises only as high as the target rate during expansions, then people will come to expect that inflation will end up below the target on average over long stretches. Hypothetically, if expansions with 2 percent inflation occur 80 percent of the time and recessions with 1 percent inflation occur 20 percent of the time, then long-run inflation expectations will equal 1.8 percent. Again, lower inflation expectations would put downward pressure on inflation rates.
The goal of the Federal Reserve’s new approach to its inflation objective is to raise (where appropriate) and better anchor inflation expectations to facilitate the Federal Reserve’s ability to reach and maintain inflation at 2 percent on average over time. Going back to the earlier hypothetical example, if inflation were to run at 2.25 percent instead of 2 percent during expansions, then long-run inflation expectations would move up from 1.8 percent to 2.0 percent. The overshoot that allows inflation to run above target raises inflation expectations by making up or compensating for episodes when inflation runs below target.