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Announcement

The seasonally adjusted rate of change in the consumer price index during the month of October 2001 was -0.3 percent or a decrease of three-tenths of one percent. The consumer price index has increased over the last twelve months by 2.1 percent.

In October, 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 October was a negative 4.0 percent. That means if prices continued to change at this month's rate and did so for an entire year, average prices will have decreased by four percent. In September consumer prices increased at an annual rate of 4.8 percent. The decrease in prices during October is primarily due to decreases in the prices of energy and transportation. 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 remains at 0.2 percent for the fourth straight month, an annual increase of 1.9 percent.

Declines in the consumer price index in a single month do not indicate downward trends in price levels. Declines are unusual, but the last monthly decline occurred in July of this year. A single month decline should not be surprising in an economy where inflation is quite low.

Figure 1 below shows recent inflation data reported for each month. Inflation increased in 1999 and 2000 when compared to1998, slowed throughout much of 2000, and then increased slightly in 2001. If inflation is considered over 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, inflation has been decreasing since that point. Over the third quarter, inflation is actually zero.

What is really quite obvious from figure 1 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. See figure 2.

Figure 1: Monthly Inflation in Consumer Prices at Annual Rates

Figure 2: Monthly Core Inflation Rate (excludes food and energy)

Compared to the rates of inflation in the 1970s and much of the 1980s, the current rate of inflation is quite low. See figure 3 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 3: 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 October was 177.6. 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 October 2001 by 77.6 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 October was 177.6, compared to 178.2 in September. The increase in prices from October to September was (177.6-178.2) / 178.2 = -0.0033 or a monthly inflation rate of -0.3 percent. It is reported to the nearest one-tenth of a percent, in this case, -0.3 percent. To convert this into an annual rate, you could simply multiply by 12. This approximates an annual inflation rate of (-0.3)(12) = -3.6 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
September 178.2
177.6 - 178.2
178.2
= -0.0033 or -0.3%
0.960312 = -0.0397 or -4.0%
October 177.6

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 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 October 24, 2001, in preparation for the FOMC meeting on November 6, 2001.

"Reports from all Federal Reserve Districts indicate weak economic activity in September and the first weeks of October. In all Districts, the tragedy of September 11 was followed by a short period of sharply reduced activity. Business activity recovered quickly from some aspects of the shock, such as reduced air cargo capacity, but longer-run effects are more difficult to assess. Retail sales, other than autos, were slightly lower than before September 11, but this weakness might have already been in train. The same is true for manufacturing. Insurance premiums have increased, and security precautions are disrupting productivity.

"Retail sales softened in September and early October in almost all Districts. Auto sales fell at the beginning of the period but have now rebounded following new zero-financing incentive plans. Both shipments and orders for a broad spectrum of manufactured goods, ranging from steel to semiconductors, are weak in most of the country. Construction generally slowed during the period. The softness in consumer spending, manufacturing, and construction is affecting the labor market, where layoffs and plant closings have been reported in many industries, from financial services on the East Coast to media and advertising on the West Coast to auto parts in the central states. There has been little upward pressure on either wages or prices, and, in some cases, they have actually fallen. Dallas and San Francisco also report an increase in health care costs.

"Most Districts report steady or declining consumer prices. Districts reporting steady retail prices included Kansas City and Richmond. Districts reporting lower retail prices included Atlanta, Boston, Chicago, and Dallas. Input prices are reported as decreasing or holding steady, except in Cleveland, where they were mixed."

The Beige Book report can be found at:
www.federalreserve.gov/FOMC/BeigeBook/2001/20011128/Default.htm

Between January and November 2001, the Federal Reserve's Open Market Committee decided to lower the target federal funds rate ten times, for a total decrease of 4.5% in the target federal funds rate. The discount rate was also lowered each time. Here is an excerpt from the minutes of the November 6, 2001 meeting - the last time the federal funds rate was lowered.

"Heightened uncertainty and concerns about a deterioration in business conditions both here and abroad are damping economic activity. For the foreseeable future, then, 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."
"Although the necessary reallocation of resources to enhance security may restrain advances in productivity for a time, the long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate."

The original press release is available at:
www.federalreserve.gov/boarddocs/press/general/2001/20011106/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.