By Heather Hennerich, Editor
Imagine if prices were not stable: Say that one day a gallon of milk costs $5, and the next it costs $10. What would happen?
If your salary remained the same, the sudden change in prices would likely generate a lot of uncertainty and anxiety, said Paulina Restrepo-Echavarria, a St. Louis Fed senior economist. She explained the importance of stable prices for everyday consumers in a 2-minute video, which is included at the end of this post.
“You don’t want the prices of the regular goods that you’re buying in your everyday life to be changing around,” Restrepo-Echavarria said.
Ensuring that consumers and firms don’t face that uncertainty is important. It’s so important that price stability is one of the economic goals Congress assigned to the Federal Reserve as part of the central bank’s “dual mandate.” (The other is maximum employment.)
But what exactly is price stability?
Two definitions in the Econ Ed at the St. Louis Fed glossary help lay it out:
It’s worth noting that, while the Federal Reserve has defined its price stability objective as being a low (2%) and stable rate of inflation, others have different definitions. Some would define price stability as a 0% inflation rate, for example.
If a lack of stable prices causes the uncertainty and anxiety that Restrepo-Echavarria mentioned, then stable prices have the opposite effect. With price stability, consumers and businesses don’t have to worry about rapidly rising or falling prices when making plans or when borrowing or lending for long periods, according to a Frequently Asked Questions page on the Federal Reserve’s Board of Governors website.
But the price of a gallon of gasoline can go up and down quickly. If gasoline prices rise by 30 cents a gallon in a short period of time and you adjust your road trip plans accordingly, does that mean the inflation rate is not “low and stable”?
Not necessarily. The inflation rate is a percentage increase in the average price level of goods and services, specifically, many goods and services, said Scott Wolla, economic education coordinator, in an Economic Lowdown podcast episode. The rising or falling prices on any single item don’t necessarily mean that the rate of inflation is increasing or decreasing, he said in the episode, “Getting Real about Interest Rates.”
“When the inflation rate goes up, it indicates that the prices of many goods and services are going up—your dollars will then buy less than they did before,” Wolla said.
Another way to think about inflation is in terms of the “basket” of goods and services that consumers buy. Inflation means that the total cost of the collection of goods in the basket is rising, but not necessarily the prices of individual goods within the basket—some of which could be falling while others are rising or not changing while the total cost of the basket is rising.
The Federal Open Market Committee (FOMC), which is the main monetary policymaking body of the Federal Reserve, aims for inflation that averages 2% over time as measured by the personal consumption expenditures price index.
When households and businesses can reasonably expect 2% inflation over the longer run, it “helps them make sound decisions regarding saving, borrowing, and investment, thus contributing to a well-functioning economy,” according to the previously mentioned Board of Governors’ Frequently Asked Questions page.
The “Getting Real about Interest Rates” episode offered an example of an economic decision affected by inflation: mortgage lending. A bank charging a consumer a fixed 6% interest rate on a 15-year mortgage would lose out if the inflation rate suddenly rose, say from 3% to 7%.
The interest rate charged or quoted by lenders is the “nominal” interest rate. The “real” interest rate is the nominal interest rate minus the inflation rate.In this scenario, the inflation-adjusted, or real, interest rate went from 3% to -1%.
Conversely, say inflation decreased to 1%. This would mean the real interest rate on the mortgage went from 3% to 5%. In this scenario, the borrower would become worse off and the lender would become better off, Wolla explained.
Without knowing that the inflation rate would be low and stable, it would be hard for a bank to know what mortgage terms to offer. And it would be hard for the consumer to decide which terms to accept.
“You can see that a stable, predictable inflation rate can take much of the guesswork out of the decision to save, borrow or lend,” Wolla said.
The stable, predictable inflation rate Wolla mentioned takes us back to the definition of price stability: a low and stable rate of inflation maintained over an extended period of time.
Prices affect everyone’s life day to day, Restrepo-Echavarria said.
“Price stability is absolutely needed for reducing uncertainty in the economy and [keeping] people at ease about the fact that their wages are going to be enough tomorrow to buy whatever they need to buy,” she said.