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 Bank-sponsored inflation event.
Questions and answers last updated December 22, 2021
Have you changed your view on whether higher inflation is temporary or here to stay?
In an earlier inflation Q&A published in September 2021, we cited several reasons why we believed that high inflation would not last. We still believe inflation will moderate from its recent high readings, but we now expect it will take longer for inflation to return to lower levels. The principal factor underlying this changed view is that the combination of very strong demand and ongoing supply chain disruptions and bottlenecks is likely to last longer than we had expected previously. On the demand side, the economy is making great strides in recovering from the pandemic-induced recession. On the supply side, however, while there are some improvements in supply chains that are beginning to occur, many businesses think that disruptions will linger well into 2022, if not longer. Consequently, the high inflation readings we’ve been seeing lately are no longer being driven by a limited number of items, such as new and used cars, but instead are more broad-based across the goods and services that people buy. The more expansive scope of price pressures is visible when looking at measures of inflation that exclude extreme price movements (which usually are not expected to persist) and that focus on price movements toward the center of the distribution of price changes (which are more likely to be sustained), such as the Cleveland Fed’s median CPI (Consumer Price Index), trimmed-mean CPI, and median PCE (Personal Consumption Expenditures Price Index) inflation rates. Plotting these inflation measures, which you can do on the Inflation Charting portion of the Cleveland Fed’s website, shows a steady upward movement since March 2021 and that they’ve been above their pre-pandemic levels since September 2021. History suggests that these median and trimmed-mean inflation measures are useful indicators of the inflation trend, and they support the view that inflation is likely to stay elevated in the near term.
However, it’s significant that some other developments remain consistent with our initial outlook that inflation will moderate over time. A number of measures of longer-run inflation expectations, including this data series produced at the Cleveland Fed, have remained relatively stable in response to the incoming inflation data. We also continue to expect that pent-up demand pressures and supply chain disruptions and bottlenecks will fade gradually and put less upward pressure on inflation. Taken together, the anchoring of inflation expectations along with the normalization of demand and supply conditions will work to bring about lower inflation readings back down, albeit at a later date than we estimated in our original timeframe.
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 Center for Inflation Research webpages.
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.
If the Fed mandate includes "stable prices" how does a 2% target even exist? 2% inflation over a not-unusual 20-year retirement means an increase in prices of nearly 50% in that 20th year.
The Federal Open Market Committee (FOMC), the monetary policymaking body of the Federal Reserve System, has a long history of seeking a low, stable, and positive inflation rate. Sustained inflation rates around 2 percent are often associated with good economic performance: a lower ongoing inflation rate might make it harder to prevent the economy from falling into deflation should economic conditions become weak, while a higher ongoing inflation rate could prevent the public from making accurate longer-term economic and financial decisions and may entail a variety of costs. Positive inflation targets also help to lessen the constraints on monetary policy imposed by the zero lower bound on nominal interest rates. It is worth noting that a number of central banks from all over the world have inflation objectives, and many of them also target an inflation rate of about 2 percent.
In 2012, the FOMC established that it viewed inflation at the rate of 2 percent, measured by the annual change in the price index for personal consumption expenditures, as being most consistent over the longer run with the Federal Reserve’s statutory mandate (see the FOMC’s original Statement on Longer-Run Goals and Monetary Policy Strategy). Last year, the FOMC released a revised statement after conducting a review of its monetary policy strategy, tools, and communications.
About the Researchers
The views expressed herein are those of the authors and are based on information available at the time of the last update and do not necessarily reflect the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.