Return

Announcement

The seasonally adjusted rate of increase in the consumer price index during the month of April 2001 was 0.3 percent or three-tenths of one percent. The rate of increase in the consumer price index over the last twelve months was 3.3 percent.

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

Data Trends

The annual rate of inflation during April was 3.4 percent, about the same as for the last twelve months. This is a faster rate of increase than in March when the annual rate was only 0.7 percent. The increase from March is primarily due to rapid increases in the price indices for petroleum-related energy. Prices of tobacco products and recreation also increased during the month. Price indices for apparel and lodging away from home decreased.

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 April is unchanged from March at 0.2 percent. At an annual rate, the core index rose 2.6% during April.

As shown in the graph below, inflation has increased since 1998, but had been slowing during the last part of 2000. If inflation is considered by quarters during 2000, the annual rates of increase were 6.1, 2.6, 2.8, and 2.1 percent. During the last three months inflation has been at an annual rate of 2.5 percent. What is really quite obvious from the graph is that changes in the rate of inflation from month to month are much more dramatic from 1999 on, when compare to 1998. The increased volatility is primary 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.

Monthly Inflation in Consumer PRoces 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. Few observers describe the current rate as high and it is not, when compared portions of the past thirty years.

Inflation in Consumer Proces since 1970

The Future of Inflation

The Federal Reserve met on Tuesday, May 15, 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 50 basis points to 4 percent. In a related action, the Board of Governors approved a 50 basis point reduction in the discount rate to 3-1/2 percent."

"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."

"In taking the discount rate action, the Federal Reserve Board approved requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Richmond, Chicago, St. Louis and San Francisco."

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 May 2, 2001, in preparation for its meeting on May 15, 2001.

"Almost all districts report a slow pace of economic activity in March and early April."

"Retail prices are steady in most districts except Richmond, where retail prices have been rising at a quicker pace in recent weeks. By and large, non-energy input costs are stable, with only a few exceptions. Manufacturing materials prices in the Chicago and Kansas City districts, for example, continue to rise, while construction materials prices in the Minneapolis district have decreased somewhat. The Dallas district is experiencing downward price pressures for metals and high-tech products. The Atlanta and Chicago districts note increases in health insurance costs. Nearly all districts report that energy costs are up sharply, hitting historic highs in some areas. The trucking industry has been hit the hardest by high gasoline prices. Several districts, especially Dallas and San Francisco, report that firms are increasingly passing on these high costs to customers as fuel surcharges. Hikes in electricity costs are concerns in both the Philadelphia and, especially, San Francisco districts."

"Manufacturing activity continues to weaken across districts, with demand having fallen in most industries. Orders and production are down in the Atlanta, Boston, Chicago, Cleveland, Minneapolis, Philadelphia, Richmond and San Francisco districts. Some districts report that excess inventories, which had been growing since the beginning of the year, are starting to fall because of production cuts. In the Boston and San Francisco districts, though, manufacturers still express concerns about excess inventories. The Philadelphia district's manufacturing sector is a mixed bag, with orders down in April, but shipments steady."

"While some districts still mention that labor markets are tight, almost all note that this tightness has been easing, especially in the manufacturing sector. Most contacts in the Atlanta, Boston, Chicago, Kansas City and St. Louis districts have commented that filling vacancies has become easier. The Dallas district, however, reports that quality workers are still elusive, and construction workers are still in short supply in the Chicago and Kansas City districts. Skilled workers in the energy sector are also in short supply in the Kansas City district. The New York district notes a continuing backlog of demand for workers in the financial services industry, though this has become less pronounced in recent weeks. Employment in the St. Louis district's retail trade and service sectors are picking up because of strengthening demand."

"Upward wage pressures have generally abated. Wages are rising very moderately or are unchanged in most parts of the country except the Richmond and San Francisco districts, where scattered wage increases are noted."

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.

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 year. Changes in the price of this basket of goods approximate changes in the overall level of prices.

The seasonally adjusted consumer price index in April was 176.8. 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 April 2001 by 76.8 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 April was 176.8, compared to 176.3 in March. The increase in prices from March to April was (176.8-176.3) / 176.3 = 0.0028 or a monthly inflation rate of 0.28 percent. It is reported to the nearest one-tenth of a percent, that is .3 percent. To convert this into an annual rate, you could simply multiply by 12. This approximates an annual inflation rate of (0.28)(12) = 3.4 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 .3 percent by twelve and get an annual inflation rate of 3.6 percent.)

Month Price Level Monthly Inflation Rate Annual Inflation Rate
March 176.3 176.8 - 176.3
176.3
= 0.0028 or .3% 1.002812 = 1.034 or 3.4%
April 176.8

Costs of Inflation

Understanding and teaching students about the costs of inflation is not an easy task. There are a variety of myths and 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 could produce other goods and services we might value more.
  2. High rates of inflation discourage businesses planning and investment as inflation makes the forecasting of prices and costs more difficult than with low rates of inflation. As prices rise, people need more dollars to carry out their transactions. When more money is demanded, interest rates increase. Higher interest rates also 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 unanticipated, that 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.
  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 its full-employment level of real GDP, pulls up prices.

Alternately, inflation can be caused by increases in costs of major inputs in the economy. That type of inflation is often described as cost-push inflation. The best recent examples are inflation caused by increases in the cost of oil.

Seldom are costs or spending changing alone. As described in the announcement (below) from the Federal Reserve, if spending is increasing more rapidly than the capacity to produce, there will be upward pressure on prices. And if employers and employees begin to expect inflation, costs and prices will begin to rise as a result. The challenge to understanding the causes of inflation in the short run is identifying rates of increase in capacity and comparing those rates of increase with changes in spending. Changes in capacity are caused by increases in labor, capital, and productivity.

Inflation, in the short run, has an inverse relationship to 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.

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.

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 of prices 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 face higher prices.

A Related Announcement

The Social Security Administration announced on October 18 that Social Security payments, beginning in January, will increase by 3.5 percent, the largest increase in almost ten years. 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.

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

Other Questions for Students

  1. Suppose the CPI was 160 for June 1999, and was 180 for June 2000. What is the corresponding annual rate of inflation?
  2. The base year of the CPI is 1982-1984. What has happened to prices since 1970 if the 1970 index was approximately 40 and if the current CPI were 160?
  3. If prices increase by five percent in a year, what effect does this have on the purchasing power of individuals in the economy?
  4. What are the costs of increased rates of inflation?
  5. Calculate a consumer price index based on the following data. Calculate the indexes for the two years and determine the annual rate of inflation.

    The market basket consists of three goods - tennis balls, movie ticket, and fast-food restaurant meals.
     

    1999

     

    2000

     
     

    Quantity sold

    Price

    Quantity sold

    Price
    Tennis balls

    1000

    $1.00

    1500

    $ .90
    Movie tickets

    500

    8.00

    600

    9.00
    Fast-food meals

    400

    5.00

    500

    6.00