The seasonally adjusted rate of change in the consumer price index during the month of January 2002 was 0.2 percent or an increase of two-tenths of one percent. The rate of increase in the consumer price index over the past twelve months was 1.1 percent.
In January, the core consumer price index, which excludes energy and food prices, also increased by 0.2 percent.
Goals of the Case Study
The goals of the Inflation Case Studies are to provide teachers and students:
- access to easily understood, timely interpretations of monthly announcements of rate of change in prices in the U.S. economy;
- descriptions of major issues surrounding the data announcements;
- brief analyses of historical perspectives;
- questions and activities to use to reinforce and develop understanding of relevant concepts; and
- a list of publications and resources that may benefit classroom teachers and students interested in exploring inflation.
The Consumer Price Index rose slightly during January after declining 0.2 percent in December. In January, prices of food, housing, transportation, medical care and education and communication all increased. Large increases in gasoline prices contributed to the increase in the price level but these increases were countered by decreases in the prices of other energy and apparel. The core rate of inflation represents the consumer price index without the influences of changes in the price indices for food and energy, which can fluctuate widely from month to month. The core rate of inflation increased to 0.2 percent for the month of January, an increase from 0.1 percent in December.
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 eight quarters of 2000 and 2001, the annual rates of change were 6.1, 2.6, 2.8, 2.1, 4.0, 3.7, 0.7 and -2.0 percent. The rate of inflation increased in January through May of 2001. Inflation has been decreasing since that point. During the fourth quarter, the price index was actually decreasing. 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. In January, the rate of inflation is the same as the core rate of inflation. See figure 2.
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. .
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 January 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 January 2002 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 January was 177.6, compared to 177.3 in December. The increase in prices from December to January was (177.6-177.3) / 177.3 = 0.0017 or a monthly inflation rate of 0.17 percent. It is reported to the nearest one-tenth of a percent, in this case, 0.2 percent. To convert this into an annual rate, you could simply multiply by 12. This approximates an annual inflation rate of (0.2)(12) = 2.4 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.
Month Price Level Monthly Inflation Rate Annual Inflation Rate
1.001712 = 0.0205
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.
- 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.
- 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.
- 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.
- Inflation does reduce the purchasing power of money.
- 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.
If average prices were to fall over a significant period, economists would describe the economy as experiencing deflation. But a single month decrease in prices would not be described as such, just as a single increase in prices is not described accurately as inflation. Deflation can be caused by a decrease in spending in the economy, which also means that real GDP would be falling. That type of deflation can occur in a relatively serious recession.
It is also possible for prices to fall as a result of falling input prices or widespread increases in productivity. In this case, the economy would be experiencing an increase in real GDP, an outcome certainly to be preferred over the recessionary deflation.
A Market Basket of Goods and Services
The Consumer Price Index measures prices of goods and services in a market basket of goods and services that is intended to be representative of a typical consumer's purchases. The percentages that are currently used to describe the categories of goods and services that market basket are as follows.
|Food and beverages||16 %||Recreation||6 %|
|Housing||41 %||Education||3 %|
|Clothing||4 %||Communication||3 %|
|Transportation||17 %||Other goods and services||4 %|
|Medical care||6 %|
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 January 16, 2002, in preparation for the FOMC meeting on January 29/30, 2002.
"Reports from the Federal Reserve Districts suggest that economic activity generally remained weak from late November through early January. But while there are still indications of caution, there are also scattered reports of improvement. The Dallas and San Francisco Districts report a continued decline in activity, while the Cleveland District indicates that the regional economy appears to be in the process of bottoming out. Economic activity remained slow or weak in the Boston, Chicago, Philadelphia, Kansas City and St. Louis Districts. Activity was mixed according to the Atlanta, Minneapolis and Richmond Districts and showed further signs of rebounding in the New York District.
"Many Districts indicate that their contacts believe a recovery will begin by mid-year or earlier, but the timing and strength are uncertain. Several Districts say that uncertainty has led some businesses to budget conservatively for the first quarter. Manufacturing activity was weak or down in most reports, but showed signs of stabilizing or rebounding in several Districts. Retail sales picked up in late December and early January but for the period overall posted generally weak results in most Districts.
"Labor markets remain soft, according to most District reports. Further layoffs are expected in the Boston District, but the Chicago and New York Districts say labor markets are stabilizing. While there were reports of shrinking pay increases in the Chicago District, some firms are freezing pay scales in the Boston District, and downward wage pressures are reported in the Cleveland, Kansas City and San Francisco Districts.
"Districts report declining prices for most goods and services with the notable exception of security, health care and medical, property and liability insurance. The Atlanta, Boston, Dallas, Minneapolis and New York Districts report steep increases in insurance costs.
"Energy costs are lower and, as the Cleveland District notes, firms have reduced or eliminated energy surcharges. According to the Dallas District, warm weather and flagging demand led to declines in natural gas, crude oil and refined product prices. Forecasts of colder weather and collaboration between OPEC and non-OPEC producers to restrict crude oil production led prices to bounce back to just below mid-November levels. Inventories of most energy products, however, are significantly higher than a year ago."
The Beige Book report can be found at:
Between January and December 2001, the Federal Reserve's Open Market Committee decided to lower the target federal funds rate eleven times, for a total decrease of 4.75% in the target federal funds rate. The discount rate was also lowered. At the most recent meeting, on January 29 and 30, 2002, the Federal Reserve decided to leave the target federal funds rate unchanged. Below is an excerpt from their announcement.
"The Federal Open Market Committee decided today to keep its target for the federal funds rate unchanged at 1-3/4 percent.
"Signs that weakness in demand is abating and economic activity is beginning to firm have become more prevalent. With the forces restraining the economy starting to diminish, and with the long-term prospects for productivity growth remaining favorable and monetary policy accommodative, the outlook for economic recovery has become more promising.
"The degree of any strength in business capital and household spending, however, is still uncertain. Hence, 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:
- What are the key parts of the consumer price index and the Federal Reserve announcements?
- What are the relevant economic concepts?
- What are the policy options for the Federal Reserve?
- Analyze current conditions with regard to policy options.
- Based on the analysis and the goals, choose the correct economic policy.