The Basics of Inflation

Laura Girresch: Welcome to the St. Louis Fed’s Timely Topics podcast series where we interview economists about their research. I’m Laura Girresch, your host. In this episode, we’ll be discussing something that’s at the top of everybody’s mind when it comes to the economy – inflation – with Chris Neely , a vice president in the Research division at the Federal Reserve Bank of St. Louis. Chris, thanks for joining us. So let’s start with the basics. What is inflation? We hear about it and see it when we pay more for goods and services, but could you tell us in your words?

Chris Neely: Sure, Laura. So inflation is a sustained rise in the general price level. Sustained means that the price rise continues over a prolonged period, that is years, not months. And by general price level, I mean the overall cost of living. Inflation isn’t really a rise in the price of a particular good like gasoline or bread because some prices will always be rising, even if the overall cost of living isn’t rising. So economists measure inflation with two commonly used price indices: The Consumer Price Index, or CPI, and the Personal Consumption Expenditure Price Index, which is usually abbreviated as PCE. Before 2002, the Federal Open Market Committee, that is the FOMC, focused on CPI inflation but since that time, the FOMC has preferred to focus on an explicitly target, PCE inflation, because the latter is more comprehensive and deals better with how people substitute between good when relative prices change.

Girresch: Can you put the inflation we’ve experienced in the U.S. in the past year in some historical context as far as the magnitude and what’s contributed to it?

Neely: Well, that’s a good question. So in the summer of 2022, inflation rose to its highest levels since 1981 and food and energy prices drove much of the increase, and these were driven in part by the Russian invasion of Ukraine and the concomitant increases in commodity prices. Supply chain disruptions from Covid-19 could also have contributed to the large price increases. But I should emphasize that one shouldn’t exaggerate the effect of food and energy and other supply disruptions. So there is a measure of inflation that takes out food and energy called Core CPI and even Core CPI inflation rose to a 40-year high last summer, coming in at or near 6% for 12-month changes. So that indicates that this really isn’t just about food and energy, or at least not directly. The cost of housing rose strongly as well and this contributed to an unusually large difference between CPI, which has a higher weight for housing, and PCE inflation.

Girresch: So how does this play out in the economy? The broader impact, beyond having to adjust our weekly budgets.

Neely: So inflation has many deleterious effects, some of which are subtle. High and variable inflation, in particular, complicates people’s calculations about borrowing money, saving for retirement, starting a business, or buying a house. That is, people in firms are going to make more mistakes in the presence of high and variable inflation, and these mistakes will be costly, but the source of the mistakes will not be obvious. So one simple way in which high and variable inflation contributes to more mistakes in people’s calculations is that it makes compounding inflation over long periods more important. So let me give you an example to flesh that out.

For example, if I asked you, how much the price level would rise if inflation were 2% a year for 10 years, you might give me an answer of about 20%. And that answer would be almost correct because the true answer would be almost 22%. But if instead of 2%, if inflation were running at 10% and I asked you, how much would inflation at 10% a year for ten years raise the price level, people would probably find that calculation pretty hard to do. And, in fact, the correct answer is that the price level would rise by almost 160% over 10 years in the presence of 10% annual inflation.

In addition to problems with compounding, in the presence of high and variable inflation, relative prices tend to change a lot and these cause people to make mistakes. So for example, when people are planning to build a factory, the factory is designed under certain assumptions about how much it will cost, for instance, to hire workers versus renting capital or using land. And in the presence of high and variable inflation, these predictions about the relative costs of land versus workers versus other capital are likely to have mistakes built in them.

Because of these mistakes, the production of goods will be more costly, and everybody will have to pay more. In addition, families are going to make mistakes in their own budgeting, and budgeting is going to be more costly. So for example, if a family is trying to decide between buying apples and oranges, it’s going to decide based on the relative price of apples and oranges, but in the presence of high and variable inflation, the relative prices of apples and oranges can change frequently so families are going to have to spend a lot of effort trying to figure out how much they should spend on each of those types of fruit. So that’s going to cost them time and effort as well. So inflation has a lot of subtle costs and people just really don’t like it.

Girresch: So at the root of it, what causes inflation?

Neely: That’s a very good question. When people think about inflation, they often think about government spending or supply shocks such as we saw with Covid-19 or with the Russian invasion of Ukraine. They often think of those as causing inflation and certainly those can cause changes in prices that can last for many months or even a year or two. But these changes tend to be limited. In the longer run, we have to think about inflation as a so-called monetary phenomenon and let me explain what I mean by that.

There was an economist named Milton Friedman who did a lot of research into monetary policy and inflation. In fact, he won a Nobel Prize in economics for his work on the topic. Friedman, by the way, has a special connection with the St. Louis Fed in that the first research director at the Bank, Homer Jones, had been Friedman’s teacher when Friedman was just an undergrad. Now, over 50 years ago, Milton Friedman taught the profession that inflation is always and everywhere a monetary phenomenon. And what did he mean by monetary phenomenon? Well, he meant interest rates and money. That is, although fiscal expansion or supply shocks can certainly raise specific prices and even cause the general price level to rise for a while, such a rise can’t continue over a period of years unless a central bank provides additional stimulus, which Freidman equated to an increase in the quantity of money. That is, the Russian invasion raised the price of oil, which caused an increase in the price level, but that increase won’t continue unless the Federal Reserve provides more money to the economy. In cases of very high levels of inflation, that is, hyper-inflations in which prices rise by more than 40% a month, are almost always produced by central banks trying to fund a fiscal deficit with money creation.

Girresch: So what are some of the ways to control inflation? You know, what’s the target and why?

Neely: Well, if inflation’s ultimately a monetary phenomenon, that is, if it’s ultimately created by central banks providing too-easy monetary policy, then the way to control it is to tighten monetary policy. That is, for central banks to provide less monetary stimulus. In other words, to raise interest rates. So Chair Powell and other members of the FOMC have been very clear that they intend to use monetary policy to control inflation. Several economists, including Milton Friedman, the former president of the St. Louis Fed, Bill Poole, and an economist who used to work here, Ed Nelson, have argued that the inflation of the 1970s was largely caused by policy makers failing to understand and act on the idea that monetary policy caused inflation.

But now we have a better understanding and the FOMC is acting on the idea that monetary policy is ultimately responsible for inflation. Now, there have been other ways, other policies that have attempted to control inflation. So in the past, governments have tried to control inflation with other strategies, most notably price controls. Now price controls are government regulations on wages or prices. Governments often regulate prices in a narrow market, such as they do when they impose rent controls or the minimum wage. But less commonly, they impose price controls on a broad range of goods and services, such as they did during World War II. Many listeners won’t be aware that the U.S. and other western countries commonly used broad price controls into the 1970s. We tend to think of price controls or broad price controls as things of the very distant past but, in fact, they’ve been used in most of our lifetimes. So most economists believe price controls to be costly and ineffective in most situations. They lead people to make bad economic decisions and waste resources in several ways. I wrote a Regional Economist article about price controls and why they’re not a good idea and it was published in early 2022, if our listeners want to learn more about price controls.

Girresch: Okay. So as we look at how to control inflation and what the path for that is, what are some of the uncertainties and risks that are on the minds of economists?

Neely: Well, we have to remember that tighter monetary policy effectively means raising interest rates, and the immediate effect of higher interest rates are to make investment and mortgages more costly. They make stocks somewhat cheaper and the dollar more expensive on foreign exchange markets. So all of these changes in asset prices, that is higher interest rates, cheaper stocks and the more expensive dollar are going to tend to slow U.S. economic activity in the short run. So historically in most cases, reducing inflation has been associated with falls in real activity, including recessions.

One of the best-known examples in U.S. history occurred during the so-called “Volcker Disinflation” that began in 1979. It was called the Volcker Disinflation because the Fed chair at that time was Paul Volcker. Now, over a period of several years in the late ’70s and early ‘80s, the Fed substantially tightened monetary policy, which greatly reduced inflation, but also contributed to a severe recession in the early ‘80s, which featured high unemployment. Now, the extent to which tighter monetary policy is associated with less real economic activity is complicated by the fact that expectations about inflation and monetary policy play a key role in how costly it is to reduce inflation. If people expect high inflation to continue when central banks tighten, then they will ask for larger wage increases and accept higher prices and higher nominal interest rates. This will make it costly to bring down inflation. On the other hand, if people expect inflation to decline, then they will accept lower wage increases and balk at paying higher prices or interest rates. This will tend to bring down inflation while minimizing the cost in unemployment.

So in other words, if people expect inflation to fall rapidly, then it does tend to fall rapidly with relatively little loss in real activity and little unemployment. But if people don’t expect inflation to come down, then bringing it down is often very costly. So opinions differ as to the extent that the present disinflation will be associated with a slow-down in activity. Former Treasury Secretary Larry Summers has emphasized that declines in inflation have usually been associated with unpleasant declines in real activity, such as those that occurred in the Volcker Disinflation. On the other hand, some on the FOMC including President Bullard, believe that the FOMC has credibility in bringing down inflation and that the current tightening might not significantly affect real activity.

Girresch: When inflation is at-target, what should that look like for consumers and the U.S. economy?

Neely: So the FOMC has long kept an eye on inflation, even before it had an official target. But as you know, since 2012, the FOMC has had an explicit target for PCE inflation of 2%, and the FOMC reaffirms this target each year in its Statement on Longer-Run Goals and Monetary Policy Strategy. When inflation returns to its target, which we all hope will happen soon, consumers and firms will find it easier to make long-run decisions about how to save and invest, which should create an economic environment that’s better for everyone.

Girresch: Absolutely. You’ve given us a lot to think about today. To read Chris’s research and hear previous podcast episodes, visit stlouisfed.org. That’s where you’ll find all of our Timely Topics podcast episodes where we feature conversations with research economists and others from the St. Louis Fed. You can also find Timely Topics on Apple podcasts, Spotify, or wherever you like to listen to your podcasts. Chris, thanks so much for your time today.

Neely: Thanks very much, Laura. It’s been a pleasure talking to you.