Written by Jayne Bills

What is Inflation?

Inflation is one of those things you may hear about often, but you have little understanding of what it actually means or why it matters. In fact, there is a longstanding debate among economists over how inflation works and how concerned we should be about it. There are always pessimists who warn that whirlwind inflation is on the horizon and point back to the 1970s as an example of rampant, uncontrollable inflation. On the flip side, there also seems to always be a camp of people urging the naysayers to calm down.

So, what is inflation? Inflation refers to the general rise in prices for goods and services in an economy over time. Higher inflation increases the cost of living and shrinks purchasing power. In other words, when inflation goes up, you can buy less goods and services with the same amount of money.

What is and what is not an accurate indicator of inflation?

There are various ways to measure inflation, and each one may tell a different story. The most popular measure of inflation in the US is the Consumer Price Index (CPI), published by the Labor Department’s Bureau of Labor Statistics. The CPI measures the average change in prices paid by urban consumers for a given basket of goods, like food, clothing, housing, and transportation. The Personal Consumption Expenditure Price Index (PCE) is another measure of inflation. PCE, published by the Commerce Department’s Bureau of Economic Analysis, is the measure that the Federal Open Markets Committee (FOMC), which sets the Federal Reserve’s monetary policy, uses to judge inflation (more on that topic later).

The CPI and PCE rely on different baskets of goods and use different weights and formulas in their calculations. The PCE tends to capture a broader picture of spending, typically resulting in a lower inflation measure than the CPI. Many economists argue that the CPI distorts the true picture of price trends in the economy.

CPI and PCE Levels

Source: FRED, Federal Reserve Bank of St. Louis.

Weight Effect

In calculating an index, the prices for all goods in the index are not equally weighted. Generally speaking, the more money people spend on a certain item, the more heavily the price of that item is weighted in the index. For example, your overall personal spending level is impacted more by a rise in the price of gasoline compared to an increase in the cost of limes. When prices are rising, you will probably not be able to reduce the amount of gas you consume as easily as you may decrease the amount of limes you purchase (driving to work tends to be less optional than that pitcher of margaritas), so gas and other essential goods tend to be more heavily weighted in a price index. CPI and PCE rely on different estimates and weights for the basket of goods. The CPI relies primarily on the Consumer Expenditure Survey, a household survey conducted by the Census Bureau, to determine its relative weights in the index, whereas the weights used in the PCE index are informed by the Census Bureau’s business surveys. The result is that the CPI is based on what households are buying, and the PCE is based on what businesses are selling.

Coverage or Scope Effect

The CPI covers out-of-pocket expenditures on goods and services purchased and paid for directly by the consumer. It excludes any other expenditures that are not paid for directly, for example, medical care paid for by employer-provided insurance. In contrast, such indirect costs are included in the PCE index. Said another way, the PCE is like one big shopping cart for all Americans that measures the price of the goods and services we consume, whether we pay for them ourselves or not. For example, at the doctor’s office, you pay the co-pay but insurance pays the rest. The PCE captures both what you pay and what insurance pays. The CPI only measures what we pay for ourselves, and tends to be somewhat higher than PCE.

Formula or Substitution Effect

The PCE contemplates substitution among goods when something gets more expensive. So, if the price of bananas goes up, the PCE takes into account that some people will start buying apples instead. The PCE captures the switch to the lower cost good, while the CPI does not.

The Bureau of Economic Analysis publishes quarterly data called Table 9.1U that explains the divergence between the PCE and CPI. The chart below was generated from Table 9.1U data. Starting with the PCE for the first quarter of 2021 on the left and ending with the CPI measure for that same time period, this chart walks through the various differences between the calculations for the two price indexes, reflecting the Weight, Coverage, and Formula or Substitution Effects mentioned above. In a deviation from the usual trend, the PCE and CPI were actually nearly on par for the quarter illustrated here, but the chart highlights how each measure differs.

How to Convert One Flavor of Inflation to Another

Reconciliation of PCE price index and Consumer Price Index for first quarter of 2021.

The Base Effect

In late spring 2021 as the economy thought it was in the throes of emerging from a global pandemic, headlines were ablaze with seemingly alarming year-over-year inflation data. The April CPI rose 4.2% versus the prior year, the fastest rate since September 2008. But the headline data may not be as bad as it sounds. Prices tumbled in March and April of 2020, when the pandemic tore through the economy, and finally rebounded. As a result, year-over-year price increases look much higher than most consumers are used to. One could argue that inflation rates are inflated! A similar theme presented itself in the May 2021 CPI numbers, as the May 2020 CPI deviated so much from the trend line that it significantly skews the 12-month comparison.

The Base Effect in the CPI: The Pandemic Dip

Source: Federal Reserve

Headline vs. Core Inflation

The CPI and PCE each have two variations: so-called “headline” inflation and “core” inflation. Core inflation excludes food and energy prices, which tend to be quite volatile, impacted by unpredictable factors like oil supply and severe weather. Over the short term, the core measure may give a more accurate reading of where inflation is headed, but headline inflation more accurately represents people’s actual expenses. Consider again, for example, the CPI numbers for April 2021. Year-over-year, the index was up 4.2%, but the core index increased by only 3%. When you get rid of food, gas, and used cars (the price of which increased by 10% over the course of a month), year-over-year inflation was merely 2.6%.

You can tell different stories about what’s happening with inflation depending on which segment of the economy you’re looking at, over which time frame, and according to which measure.

Why should I care about inflation?

Inflation is one of many indicators to gauge what’s going on in the economy, along with things like unemployment, wages, and GDP. A small amount of inflation can be a sign of a healthy economy. When labor or resources sit idly in an economy running below full capacity, inflation theoretically can help increase production. Higher prices translate to more spending, which increases demand. More demand triggers more production to ramp supply levels up to meet that demand. The Paradox of Thrift (or Savings) theorizes that as the country becomes more and more productive, if prices are allowed to fall, consumers eventually learn to delay purchases in anticipation of a better deal. The net effect of these price and consumer behaviors is reduced aggregate demand, which slows production and increases layoffs, resulting in a faltering economy. The British economist John Maynard Keynes argued that some inflation was necessary to prevent the Paradox of Thrift. Similarly, the Federal Reserve believes that a slowly increasing price level keeps businesses profitable and prevents consumers from waiting for lower prices before making purchases. Some economists believe that the primary function of inflation is to prevent deflation.

Inflation can be a positive for people or institutions with significant debt. In an inflationary environment, debtors pay back their loans with money that is less valuable than the money they borrowed. This point is particularly interesting as it relates to the U.S. government, which represents the largest debtor nation in the world. Retirees might not mind a bit of inflation either, insofar as their social security payments are adjusted in line with the CPI. Each year the Social Security Administration announces the COLA, or cost-of-living-adjustment, that will be applied to social security payments, intended to help offset loss of purchasing power due to inflation. The COLA is based on the CPI. The cost-of-living adjustment for 2022 could be the largest since 2009.

There’s substantial disagreement over how worried people should be about inflation. If consumer prices are rising, but your paycheck is not going along for the ride, that would not be good. No one wants to pay more for the same products and services if they are not also taking home more disposable income.

The Tapeworm of Inflation

Warren Buffet has strong feelings on inflation. At the 2003 annual meeting of Berskshire Hathway shareholders, he cautioned investors that, “Inflation is the one thing that, over a long period of time, can turn investors’ results, in aggregate, into a negative figure. And it’s the investors’ enemy.” Even as stock prices go higher, rising inflation brings lower real returns; returns could even be negative, leaving investors with less purchasing power than they had before. The renowned investor has been warning of the perils of inflation for decades. In his 1980 shareholder letter, Buffet described high inflation as a "tax on capital" that discourages corporate investment. He explained that the "hurdle rate," or the return on equity needed to generate a real return for investors, climbs when prices rise. "The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil," Buffett added. In his 1981 letter to shareholders, Buffett explained, "Inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.” Asset-heavy businesses with skimpy returns on equity "have no leftovers" to spend on expanding, debt reduction, or issuing dividends.

What causes inflation?

The debate about inflation — how it works, where it is showing up, and why — is a longstanding one in macroeconomics. Ultimately, inflation is caused by a mismatch in supply and demand. Economics 101 - prices tend to rise when demand outweighs supply. If everyone wants to buy milk, but there’s not that much milk available, the dairy farmers can demand a higher price. A labor shortage has a similar impact on wages, something we are currently experiencing (refer to the graph below to see how the labor force participation rate has changed throughout the COVID-19 landscape). If employers are competing for a small pool of skilled workers (who might be enticed to stay home because of generous government benefits, childcare demands, or health concerns, all of which are currently contributing to depressed labor force participation rates), the workers can bid up the wages they demand. This extra income can feed into a spending splurge, putting more upward pressure on prices generally.

Civilian labor force participation rate, seasonally adjusted

Note: Shaded area represents recession, as determined by the National Bureau of Economic Research. Source: U.S. Bureau of Labor Statistics.

So, inflation happens when demand outweighs supply. We may all agree on that, but the debate comes into play when we try to understand what causes the growing demand to outpace the dwindling supply. In the current summer 2021 environment, prices are rising as companies struggle to keep up with the speedy pace of the economic reopening and recovery from the pandemic. How much blame can we place on supply bottlenecks vs. the expanded unemployment benefits, stimulus payments, and other enhanced government safety nets that were implemented in response to COVID-19? Is the Federal Reserve’s easy money policy the culprit? More on that later.

Worrying about inflation can cause inflation

Inflation expectations also matter because they can affect how businesses and people behave, in a bit of a self-fulfilling prophecy. “Inflation is one of those behavioral things that, once everybody starts worrying about it, that’s when inflation takes root,” according to Julia Coronado, a former economist at the Fed. If businesses think inflation is coming, they might increase prices, and that can push inflation up. As Randal Quarles, the Fed’s Vice Chairman for supervision, puts it, “I think that ultimately what drives inflation is people’s expectations about what they are going to need in the way of wages, which feeds into prices...” Fed Chairman Jerome Powell agrees, noting, "If people believe that prices will be pretty stable, then they will be — because they won't ask for very high wage increases and people who sell things won't be asking for high price increases. Once that psychology sets in, it tends to perpetuate itself."

What is the role of the Fed?

The Federal Reserve’s dual mandate is to achieve maximum sustainable employment and price stability. It defines the latter as an annual inflation rate of 2% on average. To help achieve that goal, it strives to “anchor” inflation expectations at roughly 2%. Former Fed Chairman Ben Bernanke argues that the Fed’s focus on anchoring inflation expectations has been the “most important factor over the long haul” in the behavior of price inflation. The mere fact that the Fed targets inflation of 2% helps keep inflation in check. The Fed is also careful to reassure the American public (and markets) that they monitor inflation very closely, they have the tools to address higher inflation, and they can do so without derailing an economic recovery.

In addition to talking points to manage inflation expectations, there are two primary ways the Fed seeks to control rising prices. First, they can reduce their monthly asset purchases (currently $120 billion in Treasuries and mortgage-backed securities), which are intended to lower long-term interest rates, making business and mortgage borrowing cheaper. Second, they could raise its short-term interest rate. This rate influences borrowing rates throughout the economy, meaning consumers would see higher interest rates on items like car loans and credit cards, but on the flip side, they would earn more on their savings, which incentivizes them to reduce purchases.

Timing is Everything

Tapering asset purchases and raising short-term interest rates are likely to rein in inflation. However, if the policy tightening is too quick or too severe, such moves have the potential to dampen economic growth and cause a recession. Conversely, there is also the risk that if the Fed waits too long to act, inflation could get beyond its control. Proper timing is critical and is often subject to debate, even among the Fed governors themselves. In late June 2021, as the economy grappled with the highest year-over-year inflation in over a decade, the Federal Reserve struggled to agree on the proper timing for raising rates and cutting asset purchases, as some of the policy makers began to question the official talking point that price increases were merely transitory, expected to reverse once the post-pandemic supply bottlenecks worked themselves out.

The Fed's policymakers have explained that temporary price increases are not the same thing as a prolonged stint of ongoing inflation. “A persistent material increase in inflation would require not just that wages or prices increase for a period after reopening, but also a broad expectation that they will continue to increase at a persistently higher pace,” Lael Brainard, a Fed governor and key voice on the central bank's interest rate policies, said in May 2021. “A limited period of pandemic-related price increases is unlikely to durably change inflation dynamics.”

2% Inflation Target

Over the past several years (prior to the 2021 rise in inflation), the economy has consistently run below the Fed’s 2% inflation target. In fact, the central bank now says its goal is an average inflation target of 2% over the long term, meaning it is letting inflation run over 2% for a while before trying to get it under control (an approach it is calling Average Inflation Targeting (AIT)). When announcing the shift to the Fed’s new AIT framework in August 2020, Chairman Powell explained the importance of ensuring inflation and inflation expectations don’t run too low: “Inflation that runs below its desired level can lead to an unwelcome fall in longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectation…Well-anchored inflation expectations are critical for giving the Fed the latitude to support employment, when necessary, without destabilizing inflation. But if inflation expectations fall below our 2 percent objective, interest rates would decline in tandem.” He went on to explain that when interest rates are already low, the Fed has less scope to cut them, which hampers their ability to lower unemployment during an economic downturn, “further diminishing our capacity to stabilize the economy through cutting interest rates.” Powell’s argument here provides context for the Fed’s summer 2021 response to rising inflation. The Fed announced that, in an attempt to get the labor market closer to full employment levels, they would allow prices to rise slightly above 2%, underpinned by wage growth, for a period of time to help make up for the past decade’s inflation shortfalls.

What can we do about inflation?

Inflation over the long term seems inevitable, and it remains largely outside of the individual consumer’s control. Heed Warren Buffet’s admonition that inflation is the investor’s enemy and use equity exposure in your portfolio to capture some benefit from rising prices. Just be sure to include a bond allocation as well to help protect your investment portfolio during inevitable market downturns, which could very well come as a result of the Fed’s policy response to rising inflation!

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