Online Lesson

Focus on Economic Data: The Inflation Rate - August 2001

Announcement

The seasonally adjusted rate of increase in the consumer price index during the month of August 2001 was 0.1 percent or one-tenth of one percent. The rate of increase in the consumer price index over the last 12 months was 2.7 percent.

In August, the core index, which excludes energy and food prices, increased by .2 percent. The core index has increased 2.7 percent over the last 12 months.

Data Trends

The annual rate of inflation during August was 0.7 percent. This is a faster rate of increase than in July, when consumer prices actually declined at an annual rate of 3.3 percent. The increase in prices is primarily due to smaller declines in the price indices for energy and transportation. The price index for tobacco and smoking products also decreased. These losses were offset by increases in the prices for medical care and housing during August.

The core rate of inflation represents the consumer price index without the influence of changes in the price indices for food and energy. The core rate of inflation in August is unchanged from July at 0.2 percent. At an annual rate, the core index rose 2.7% during August. The graph below shows recent inflation data reported for each month. Inflation increased in 1999 and 2000 when compared to 1998, but it has been slowing throughout much of 2000 and it increased slightly in 2001.If inflation is considered by the four quarters of 2000 and the first two of 2001, the annual rates of change were 6.1, 2.6, 2.8, 2.1, 4.0, and 3.7 percent. Although the rate of inflation was high in January through May of 2001, overall inflation is still slowing. Over the last three months the rate of inflation is actually zero percent. What is really quite obvious from the graph is that the changes in inflation from month to month are much more dramatic from 1999 on, when compared to 1998. The increased volatility is primarily due to fluctuations in the prices of oil and food. The core rate of inflation (excluding food and energy) gives a much better idea of longer term trends and that is why it is often featured in news reports.

Compared to the rates of inflation in the 1970s and much of the 1980s, the current rate of inflation is quite low. See the graph below. Few observers would describe the most recent rates as high; they are not, when compared to those of the past 30 years.

Definitions of Inflation and the Consumer Price Index

Inflation is a sustained increase in the overall level of prices. The most widely reported measurement of inflation is the consumer price index (CPI). The CPI measures the cost of a fixed basket of goods relative to the cost of that same basket of goods in a base (or previous) year. Changes in the price of this basket of goods approximate changes in the overall level of prices paid by consumers.

The seasonally adjusted consumer price index in August was 177.5. The price index was equal to 100 during the period from 1982 to 1984. The interpretation is that prices for a market basket of goods purchased by the typical consumer increased from the 1982-1984 period to August 2001 by 77.5 percent.

Inflation is usually reported in newspapers and television news as percentage changes in the CPI on a monthly basis. For example, the CPI in August was 177.5, compared to 177.4 in July. The increase in prices from July to August was (177.5-177.4) / 177.4 = 0.0006, or a monthly inflation rate of 0.06 percent. It is reported to the nearest one-tenth of a percent, in this case, .1 percent. To convert this into an annual rate, you could simply multiply by 12. This approximates an annual inflation rate of (0.06)(12) = .7 percent. A slightly more accurate measurement of the annual inflation rate is to compound the monthly rate, or raise the monthly rate of increase, plus one, to the 12th power. (An even more approximate method is to multiply the reported .1 percent by twelve and get an annual inflation rate of 1.2 percent.)

Costs of Inflation

Understanding the costs of inflation is not an easy task. There are a variety of myths about inflation. There are debates among economists about some of the more serious problems caused by inflation. A number of exercises in National Council on Economic Education publications, student workbooks, and textbooks should help students think about the consequences of inflation.

1. High rates of inflation mean that people and business have to take steps to protect their financial assets from inflation. The resources and time used to do so could produce goods and services of value. Those goods and services given up are a true cost of inflation.
2. High rates of inflation discourage businesses planning and investment as inflation makes the forecasting of prices and costs. As prices rise, people need more dollars to carry out their transactions. When more money is demanded, interest rates increase. Higher interest rates can cause investment spending to fall, as the cost of investing is higher. The unpredictability associated with fluctuating interest rates makes customers less likely to sign long-term contracts as well.
3. The adage "inflation hurts lenders and helps borrowers" only applies if inflation is not expected. For example, interest rates normally increase in response to anticipated inflation. As a result, the lenders receive higher interest payments, part of which is compensation for the decrease in the value of the money lent. Borrowers have to pay higher interest rates and lose any advantage they may have from repaying loans with money that is not worth as much as it was prior to the inflation.
4. Inflation does reduce the purchasing power of money.
5. Inflation does redistribute income. On average, individuals' incomes do increase as inflation increases. However, some peoples' wages go up faster than inflation. Other wages are slower to adjust. People on fixed incomes such as pensions or whose salaries are slow to adjust are negatively affected by unexpected inflation.

 Causes of Inflation

Over short periods of time, inflation can be caused by a decrease in production or an increase in spending. Inflation resulting from an increase in aggregate demand or total spending is called demand-pull inflation. Increases in demand, particularly if production in the economy is near the full-employment level of real GDP, pull up prices. It is not just rising spending. If spending is increasing more rapidly than the capacity to produce, there will be upward pressure on prices.

Inflation can also be caused by increases in costs of major inputs used throughout the economy. This type of inflation is often described as cost-push inflation. Increases in costs push prices up. The most common recent examples are inflationary periods caused largely by increases in the price of oil. Or if employers and employees begin to expect inflation, costs and prices will begin to rise as a result.

Over longer periods of time, that is, over periods of many months or years, inflation is caused by growth in the supply of money that is above and beyond the growth in the demand for money.

Inflation, in the short run and when caused by changes in demand, has an inverse relationship with unemployment. If there are high levels of unemployment, then there is less, or at least a slower growth in, spending in the economy, and inflation is subdued. If there is low unemployment, then wages are increasing to attract workers to jobs, and this creates upward pressure on prices, that is, inflation. That relationship disappears when inflation is primarily caused by increases in costs. Unemployment and inflation can then rise simultaneously.

Other Measures of Inflation

The GDP price index (sometimes referred to as the implicit price deflation). The GDP price index is an index of prices of all goods and services included in the gross domestic product. Thus the index is a measure that is broader than the consumer price index.

The producer price index. This index measures prices at the wholesale or producer level. It can act as a leading indicator of inflation. If the prices producers are charging are increasing, it is likely that consumers will eventually be faced with higher prices for goods they buy at retail stores.

The Future of Inflation

The Federal Reserve Board made the following unscheduled announcement on September 16, 2001.

The Federal Open Market Committee decided today to lower its target for the federal funds rate by 50 basis points to 3 percent. In a related action, the Board of Governors approved a 50 basis point reduction in the discount rate to 2-1/2 percent. The Federal Reserve will continue to supply unusually large volumes of liquidity to the financial markets, as needed, until more normal market functioning is restored. As a consequence, the FOMC recognizes that the actual federal funds rate may be below its target on occasion in these unusual circumstances.

Even before the tragic events of last week[terrorist attacks on New York City and Washington, D.C.], employment, production, and business spending remained weak, and last week's events have the potential to damp spending further. Nonetheless, the long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate. For the foreseeable future, the Committee continues to believe that against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness.

The Federal Reserve Board met on August 21, 2001. The following announcement was released following their formal meeting.

The Federal Open Market Committee at its meeting today decided to lower its target for the federal funds rate by 25 basis points to 3-1/2 percent. In a related action, the Board of Governors approved a 25 basis point reduction in the discount rate to 3 percent. Today's action by the FOMC brings the decline in the target federal funds rate since the beginning of the year to 300 basis points.

Household demand has been sustained, but business profits and capital spending continue to weaken and growth abroad is slowing, weighing on the US economy. The associated easing of pressures on labor and product markets is expected to keep inflation contained.

Although long-term prospects for productivity growth and the economy remain favorable, the Committee continues to believe that against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.

The Federal Reserve's report on economic conditions across the country is released in the "Beige Book" prior to each meeting of the Federal Reserve Open Market Committee. The following is an excerpt from the Beige Book released on August 8, 2001, in preparation for its meeting on August 21, 2001.

Continued slow economic growth loosened labor markets and eased wage pressures in most Districts in June and July, but rising benefit costs continued to add to compensation costs. Prices for energy, fuel, and many material inputs fell in most regions. Falling input costs and stiff domestic and foreign competition kept prices of most consumer goods in check.

Fuel and energy prices fell in June and July in most Districts, lessening the burden on businesses and easing pressure on consumer budgets. Lower gasoline prices allowed shippers and truckers to reduce or remove fuel surcharges imposed earlier this year. Lower energy costs also contributed to price declines for a number of manufactured goods. However, upward price pressure was reported for pharmaceuticals, various services, and single-family housing in some regions. In addition, retail electricity rates were up sharply in California in June, as previously authorized rate hikes took effect. In general, however, declining input costs and stiff domestic and foreign competition continued to restrain consumer prices.

Case Study

1. What are the key parts of the consumer price index and the Federal Reserve announcements?
2. What are the relevant economic concepts?
3. What are the policy options for the Federal Reserve?
4. Analyze current conditions with regard to policy options.
5. Based on the analysis and the goals, choose the correct economic policy.