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What's your question?: Inflation and Deflation

Friday, April 1, 2011

Q. The Fed’s policymaking body, the Federal Open Market Committee, usually targets the federal funds interest rate to conduct monetary policy. In response to economic conditions, the FOMC acted to reduce that interest rate to near zero in December 2008. Did the Federal Reserve substantially lower the rate in previous recessions?

A. Yes. In the graph of the federal funds rate (below), the shaded bars represent recent U.S. recessions. In these recessions, the federal funds rate dropped as a result of the Fed’s policy actions. However, the past recession was the only one where the rate approached zero.


Q. How is the inflation rate measured?

A. Although the level of inflation can be measured in several ways, one of the most widely used measurements is the consumer price index (CPI). This index is a monthly measure of the average change over time in the prices paid by urban consumers for a “market basket” (80,000 items) of consumer goods and services. This urban consumer group represents about 87% of the total U.S. population.


Q. Downward movement in the prices of goods and services (lower prices) sounds good. So why is deflation considered a problem?

A. Deflation can have undesirable “snowball” effects on an economy. Although it may sound good, a general decreasing trend in prices discourages spending and investment because consumers delay purchases while waiting for prices to drop further. For example, if the price of electronics, such as computers, tablets, and the latest phones, consistently dropped every week, you would probably delay purchasing these items until the price was as low as possible. Delayed spending results in fewer sales and less revenue for businesses, which in turn reduces the need for employees and thereby increases unemployment. Another factor to consider is the cost of credit during deflationary times. Since the value of money increases in a deflationary environment (each dollar will buy more goods and services), debtors must repay their old loans with more-valuable dollars, to the benefit of their creditors.


Q. What specific goods and services are represented in the CPI’s market basket of consumer goods?

A. The CPI is often referred to as the “all items index.” Although it does not include literally all items, it includes a representative selection of consumer goods and services. Items are divided into more than 200 categories, arranged into eight major groups:

  • Food and beverages
  • Housing
  • Apparel
  • Transportation
  • Medical care
  • Recreation
  • Education and communication
  • Other goods and services

Q. What is the core CPI?

A. The core CPI is the CPI excluding food and energy. It may seem puzzling to exclude two categories of great importance to all consumers, but here’s why it’s done. Food and energy prices tend to be more volatile and subject to more price variation—sharp and often short-term movements can obscure longer-term and underlying trends in other categories. For example, gasoline prices can change several cents per gallon overnight. By excluding food and energy, the core CPI indicates the short-run inflation trend without the risk of volatile prices concealing the true picture of that trend.



Hoda El-Ghazaly. “Deflation: Who Let the Air Out?” Federal Reserve Bank of St. Louis Liber8, February 2011;

Kevin L. Kliesen. “Is the Fed’s Definition of Price Stability Evolving?” Federal Reserve Bank of St. Louis Economic Synopses, Number 33, 2010;

U.S. Bureau of Labor Statistics. “All Items Less Food and Energy.” Focus on Prices and Spending: Consumer Price Index, February 2011, 1(15);