The Fed’s latest challenge with inflation on the rise

Bad news on the inflation front: over the past 12 months, the Labor Department said that the U.S. Consumer Price Index (CPI) rose by 5 percent from a year earlier, the biggest increase since August 2008.

The Federal Reserve (Fed) uses a different index to measure inflation, the Personal Consumption Expenditure. This index, which ignores the often volatile categories of food and energy, jumped 3.8 percent in May from the year before, the largest increase for that reading since June 1992.

Last August, the Fed adopted a historic shift to interest rate policy that places more emphasis on boosting employment, allowing inflation to rise above their 2 percent target and keeping rates lower for a longer period. The Fed said it believed that this inflation target is most consistent over the long run with meeting its challenging goals of maximum employment and stable prices, often called the dual mandate.

Now, with inflation on the rise, the critical question is whether higher than expected price increases are just because of the economy reopening or if they’re being caused by something more persistent.

Government policymakers and economists argue that it’s the former.  They claim some of the surge can be explained by a low base — prices fell dramatically last spring as consumers spent less in the face of the pandemic.  Most Americans spent last May quarantined in their homes, rather than shopping or taking a holiday, so the price of goods and services were quite low.

The Fed argues that the recent increase in inflation has been fueled by an unusual combination of short-term supply bottlenecks and pent-up demand from consumers finally emerging from their homes. Demand is also being driven by Americans who are flush with cash after multiple stimulus checks.

That said, it may be that COVID’s impact on global supply chains and production will prove more durable than anticipated and render inflation less transitory than the Fed expects. For example, the Federal Reserve Bank of Atlanta’s sticky price index, a weighted basket of items that change price relatively slowly, increased 4.5 percent in May, the largest increase since April 2009.

Also, labor scarcity is reversing decades of wage stagnation. Thanks in part to some people choosing not to look for work after Congress’s extension of an extra $300 a week in unemployment benefits until September, demand for workers is outstripping the supply, enabling workers to secure higher wages. The Fed argues that the strong labor market prior to the pandemic did not trigger a significant rise in inflation.

Inflation, defined as a general rise in the level of prices, is insidious. It erodes purchasing power over time if wages don’t keep up.  Even at an annual inflation rate of 2 percent, the purchasing power of $10,000 put under your mattress today is about $8,200 in 10 years.

By allowing inflation to rise above 2 percent, the Fed wanted to avoid inflation’s evil twin: deflation, or a sustained decline in the general price level.

Why does the Fed want to avoid falling prices? For starters, if consumers come to expect prices to decline in the future, they may delay purchases for as long as possible. Consequently, sales volume fall, corporate profits decline, unemployment rises, and the economy grows more slowly, causing prices to decline further.

There is a trade-off between price stability and maximum employment, and each scenario has winners and losers.  The intellectual heavy hitters at the Fed will surely wait for additional data before deciding whether to sacrifice full employment on the altar of price stability.  Of course, they might also face political pressure not to raise interest rates because, in an era of soaring debt and deficits, higher rates would increase government costs.

Such are the consequences in the Fed’s high-stakes game of determining whether rising inflation is a passing phase or a more permanent problem.

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