Announcement

The seasonally adjusted rate of increase in the consumer price index during the month of September 2001 was 0.4 percent or four-tenths of one percent. The rate of increase in the consumer price index over the last twelve months was 2.6 percent.

In August, the core index, which excludes energy and food prices, increased by .2 percent. The core index also increased 2.6 percent over the last twelve months.

Data Trends

The annual rate of inflation during September was 4.9 percent. This is a faster rate of increase than in August when consumer prices increased at an annual rate of 0.7 percent. The increase in prices is primarily due to increases in the price index for energy. The core rate of inflation represents the consumer price index without the influences of changes in the price indices for food and energy. The core rate of inflation in September is unchanged from August at 0.2 percent. But at an annual rate, the core index fell to 2.6% during September from 2.7 in August. The graph below shows recent inflation data reported for each month. Inflation increased in 1999 and 2000 when compared to1998, but has been slowing throughout much of 2000 and then increased slightly in 2001. If inflation is considered by the four quarters 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.

Figure 1: Monthly Inflation in Consumer Prices at Annual Rates

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 and they are not, when compared to those of the past thirty years.

Figure 2: Inflation in Consumer Prices since 1970

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 September was 178.2. The price index was equal to 100 during the period from 1982 to 1984. The interpretation is that prices in 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 September was 178.2, compared to 177.45 in July. The increase in prices from July to August was (178.2-177.5) / 177.5 = 0.0039 or a monthly inflation rate of 0.4 percent. It is reported to the nearest one-tenth of a percent, in this case, .4 percent. To convert this into an annual rate, you could simply multiply by 12. This approximates an annual inflation rate of (0.4)(12) = 4.8 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.

Month Price Level Monthly Inflation Rate Annual Inflation Rate
August 177.5
178.3 - 177.5
177.5
= 0.0039 or .4%
1.00412 = 1.049 or 4.9%
September 178.2


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.

Using the CPI as an Inflation Index

The Social Security Administration announced on October 20, 2001, that Social Security payments, beginning in January 2002, will increase by 2.6 percent. Annual changes in Social Security payments are based on changes in the consumer price index. The rate of change in consumer prices from October through September is used to calculate the appropriate change in the Social Security payments for the following year. The purpose of the adjustment is to maintain the real purchasing power of the Social Security payments.

As a result of the change, the average monthly Social Security benefit will rise from $852 to $874.

Income tax brackets and deductions also change according to changes in the consumer price index. Private contracts often also reference changes in inflation as measured by the consumer price index.

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 the 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 deflator). 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 good they buy at retail stores.

The Future of Inflation

The Federal Reserve's report on economic conditions across the country is released in the "Beige Book" (named for its beige cover) two weeks prior to each meeting of the Federal Reserve Open Market Committee. The following is an excerpt from the Beige Book released on September 19, 2001, in preparation for the FOMC meeting on October 2, 2001.

"Reports from Federal Reserve Districts generally indicated that overall economic activity remained sluggish in August and early September, with several suggesting that activity slowed further. Upward price pressures were again restrained in nearly all Districts. Input cost pressures were said to be easing as well.

"Overall consumer spending remained soft in most of the country during August and early September, while upward pressures on retail prices were subdued. Over half of the District reports indicated that retail sales were flat to down in the reporting period. Atlanta and Minneapolis reported retail sales increases, as did Dallas but from very weak levels. In the important back-to-school segment, merchants in the Boston, Chicago, and St. Louis Districts noted strong sales, while those in the New York, Philadelphia, and Kansas City regions had mixed, less-than-expected, and flat results, respectively. Federal income tax rebates had only a limited effect on spending in August, with New York and Chicago indicating no significant impact, while the Atlanta report suggested that tax rebates (along with heavy discounting) boosted overall sales. Minneapolis noted that state sales tax rebates helped retail sales. Overall lending activity was reported to be mixed, as household demand for loans remained strong in most areas while softness in business lending persisted.

The "Beige Book" report can be found at:
www.federalreserve.gov/fomc/BeigeBook/2001/20010919/default.htm

Between January and October 2001, the Federal Reserve's Open Market Committee decided to lower the target federal funds rate nine times, for a total decrease of 4.0% in the target federal funds rate. The discount rate was also lowered each time. Here is an excerpt from the minutes of the October 2, 2001 meeting - the last time the federal funds rate was lowered.

"A significant reduction in excess inventories seems well advanced. Consumption and housing expenditures have held up reasonably well, though activity in these areas has flattened recently. Investment in capital equipment, however, has continued to decline. The erosion in current and prospective profitability, in combination with considerable uncertainty about the business outlook, seems likely to hold down capital spending going forward. This potential restraint, together with the possible effects of earlier reductions in equity wealth on consumption and the risk of slower growth abroad, continues to weigh on the economy."

"With pressures on labor and product markets easing, inflation is expected to remain contained. Although measured productivity growth stalled in the first quarter, the impressive underlying rate of increase that developed in recent years appears to be largely intact, supporting longer-term prospects."

"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 original press release is available at: www.federalreserve.gov/BoardDocs/Press/General/2001/20011002/default.htm

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.