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POLICY GOALS: PRICE STABILITY
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Chapter 1
General Economic Concepts
Chapter 2
What is Policy?
Chapter 3
History of Macroeconomic Policies in the United States
Chapter 4
Policy Goals: Maximum Employment
Chapter 5
Policy Goals: Maximum Production
Chapter 6
Policy Goals: Price Stability
Chapter 7
Policy Goals: External Balance
Chapter 8
Subsidiary Policy Goals
Chapter 9
Conflicting Policy Goals
Chapter 10
The Policy Makers
Chapter 11
The Policy Instruments
Chapter 12
The Decision-Making Processes
Chapter 13
The Policy Indicators
Chapter 14
The General Economic Model
Chapter 15
Monetarist Monetary and Fiscal Policies
Chapter 16
Keynesian Monetary and Fiscal Policies
Chapter 17
Debt Management Policies
Chapter 18
Incomes Policies
Chapter 19
Supply Management Policies
Chapter 20
The Long Wave
Chapter 21
Contemporary Issues
"The significance of the great expansion of the 1960s lies not only in its striking statistics of employment, income and growth but in its glowing promise of things to come. If we can surmount the economic pressures of Vietnam without later being trapped in a continuing war on inflation when we should again be fighting economic slack, the 'new economics' can move us steadily toward the qualitative goals that lie beyond the facts and figures of affluence."

Walter Heller
American Economist
New Dimensions of Political Economy (1967)

  1. Definitions and Construction of a Price Index
  2. Measuring Performance
  3. Measurement Problems
  4. Causes of Price Instability
  5. Consequences of Price Instability
  6. Optimum Amount of Price Stability
  7. Inflation Expectations
  8. Current Trends
  9. Summary
    Readings
    Websites
top    I. Definitions and Construction of a Price Index

The third ultimate goal is price stability. Section 1021(a) of the Employment Act of 1946 provides that
"The Congress declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means, consistent with its needs and obligations and other essential national policies, and with the assistance and cooperation of both small and larger businesses, agriculture, labor, and State and local governments, to coordinate and utilize all its plans, functions, and resources for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions which promote useful employment opportunities, including self-employment, for those able, willing, and seeking to work, and promote full employment and production, increased real income, balanced growth, a balanced Federal budget, adequate productivity growth, proper attention to national priorities, achievement of an improved trade balance through increased exports and improvement in the international competitiveness of agriculture, business, and industry, and reasonable price stability as provided in section 1022b(b) of this title."
Section 1021(c) of the Employment Act provides that
"The Congress further declares that inflation is a major problem requiring improved government policies relating to food, energy, improved and coordinated fiscal and monetary management, the reform of outmoded rules and regulations of the Federal Government, the correction of structural defects in the economy that prevent or seriously impede competition in private markets, and other measures to reduce the rate of inflation."
Price stability starts with construction of a price index and is measured by the annual percentage change in the price index:

p = %changePI = (PI1 - PI0)/PI0

Price Indexes

A price index is a composite measure of the general level of prices at a point in time. The general level of prices and price stability are measured with several different price indexes.

The Consumer Price Index (CPI) measures the general level of prices paid by households for a fixed basket of goods and services. It is calculated each month on a national as well as several regional bases.

The Core Consumer Price Index (CCPI) measures the general level of prices paid by households for a fixed basket of goods and services (the CPI), but excludes prices that are extremely volatile and vary for unpredictable reasons from period to period, for example, food and energy prices.

The Personal Consumption Expenditure Price Index (PCEPI) measures the general level of prices paid by households for all goods and services. It is calculated each month on a national basis.

The Core Personal Consumption Expenditure Price Index (CPCEPI) measures the general level of prices paid by households for all goods and services (the PCEPI), but excludes prices that are extremely volatile and vary for unpredictable reasons from period to period, for example, food and energy prices.

The Producer Price Index (PPI) measures the general level of prices paid by businesses for raw materials, semi-finished goods, and capital equipment. It is calculated each month. Some element of double counting is evident as raw materials are also entered as semi-finished goods. Movements in the PPI tend to forecast future movements in the CPI and the Implicit GDP Deflator, because changes in factor input prices are eventually passed along to consumers and government buyers.

The Core Producer Price Index (CPPI) measures the general level of producer prices (the PPI), but excludes components whose prices are extremely volatile and vary for unpredictable reasons from period to period, for example, food and energy prices. Movements in the CPPI tend to forecast future movements in the CCPI and the Implicit GDP Deflator, because changes in factor input prices are eventually passed along to consumers and government buyers.

The Employment Cost Index (ECI) measures the general cost of hiring labor and includes labor's wages, salaries, fringe benefits, and perks. Movements in the ECI tend to forecast future movements in the CPI and the Implicit GDP Deflator, because changes in labor costs are eventually passed along to consumers and government buyers.

The Implicit GDP Price Deflator measures the general level of all prices. It includes components of the CPI and the PPI as well as the cost of construction and government and imported goods.

Types of Price Indexes

A Laspeyres Index takes a fixed basket of goods and calculates the index based on the cost of the basket going forward in time. (The CPI is a Laspeyres Index.)
(Laspeyres Index)t = Value of period 0 quantities in current prices
Value of period 0 quantities in current prices
= ∑ptq0
∑p0q0
A Paasche Index takes a fixed basket of goods and calculates the index based on the cost of the basket going backward in time.
(Paasche Index)t = Value of period t quantities in current prices
Value of period t quantities in current prices
= ∑ptqt
∑p0qt
A Chain-type Price Index combines the Laspeyres Index and the Paasche Index to allow for a changing composition of items in the market basket. (The PCEPI is a Chain-type Price Index.)
(Chain-type Price Index)t = SQRT(Laspeyres Index x Paasche Index) = SQRT( ∑ptq0
∑p0q0
x ∑ptqt
∑p0qt
)

Construction of a Laspeyres Index (like the CPI)

One of the years is selected to be the base year, e.g., 2002. (In the table below, the base year is Year 1.) The index for each year is calculated by dividing the current year prices by the base year prices and multiplying by 100.

PI =   Sum of Current Prices   x 100
Sum of Base Year Prices

When the "current year" is also the "base year," the index is always 100. For any other year, the current year prices and the base year prices will most likely differ. If current-year prices are greater than base-year prices, the index will be over 100. If current-year prices are below base-year prices, the index will be below 100.

CONSTRUCTION OF A PRICE INDEX (Base Year = Year 1)
Good Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
A $10.00 $11.00 $11.00 $12.00 $10.00 $10.00
B 1.00 1.00 1.00 2.00 3.00 1.00
C 5.00 4.00 6.00 5.00 5.00 5.00
D 4.00 6.00 5.00 4.00 3.00 4.00
Sum 20.00 22.00 23.00 23.00 21.00 20.00
Price Index 100.00 110.00 115.00 115.00 105.00 100.00
Annual % change   10.0% 4.5% 0.0% (8.7%) (4.8%)
    inflation disinflation no change deflation disdeflation

When the "current year" is also the "base year," the index is always 100. For any other year, the current year prices and the base year prices will most likely differ. If current-year prices are greater than base-year prices, the index will be over 100. If current-year prices are below base-year prices, the index will be below 100.

top    II. Measuring Performance

Price stability is measured by the annual percentage change in the price index.

p = %ΔP = (P1 - P0)/P0

Inflation is an increase in the general level of prices, as measured by some price index. Notice that not all prices rise during an inflation. Some prices may be falling, but those prices which are rising tend to pull up the general level of prices. In Year 2, above, the price of Good C actually falls by $1.00, but the overall level of prices increases by 10.0%.

Deflation is a decrease in the general level of prices, as measured by some price index. Notice that not all prices fall during an deflation. Some prices may actually be rising, but those prices which are falling tend to pull down the general level of prices. In Year 5, above, the price of Good B actually rises by $1.00, but the overall level of prices falls by 8.7%.

Disinflation is a decrease in the rate of inflation. In Year 2, above, the general level of prices rises by 10%. In Year 3, prices rise again, but by a smaller amount, only 4.5%.

Disdeflation is a decrease in the rate of deflation. In Year 5, above, the general level of prices falls by 8.7%. The following year, prices fall again, but by a smaller amount, only 4.8%.

Price stability is no change in the general level of prices — no inflation and no deflation. In Year 3 and Year 4, above, the general level of prices is the same. Notice that individual prices change: the prices for Goods A and B rise by $1.00 each and the prices for Goods C and D fall by $1.00 each, but the overall level of prices does not change.

Headline inflation is the annual or annualize percentage change in a price index that includes volatile prices for food and energy.

Core inflation is the annual or annualize percentage change in a price index that excludes volatile prices for food and energy.

top    III. Measurement Problems

Problems in Computing a Price Index

Regional differences Prices in major metropolitan areas tend to be much higher than prices in rural areas and the Mid-West. The composite price index cannot adequately reflect both sets of prices at the same time. Therefore, the Census Bureau has opted to calculate the Consumer Price Index, for example, from a random sampling of prices for an average "market basket of goods and services" bought by the average family of four living in a city. This procedure is faulty and tends to inflate the CPI, because it is heavily weighted by the higher prices in the major urban areas. It also fails to capture the differences in market baskets between city-dwellers and country-dwellers.

Arbitrary weighting Weighting becomes arbitrary because a small percentage increase in a large item will raise the index by more than a large percentage increase in a small item. In Year 2, if the price of Good A rises by a small 10% or $1.00 from $10.00 to $11.00 and all other prices remain the same, the index increases from 100.0 to 105.0 or 5%. If, however, the price of Good B rises by a whopping big 50% or $.50 from $1.00 to $1.50 and all other prices remain the same, the index increases from 100.0 to 102.5 or a mere 2.5%.

Temporal incongruity Construction of the index assumes that one buys a new automobile or a new house each month. In 1978, the CPI was revised and, at that time, adjusted to reflect rents rather than housing prices, per se. However, even rents do not rise each month for the average family of four living in the city! The BLS again revised the index in 1987 to reflect substantial changes in the composition of the average family's market basket.

Problems in Using the CPI as a Measure for Other Adjustments

The CPI is used for wage negotiations To the extent that the CPI goes up, so do wage demands. To the extent that the CPI overstates the representative market basket for the average family, wages will rise faster than productivity gains, thus pushing prices still higher.

The CPI is used to adjust Social Security payments To the extent that the CPI goes up, so do payments to Social Security recipients. To the extent that the CPI overstates the representative market basket for senior citizens, aggregate demand by will rise, thus pulling up prices further.

The Need for Periodic Revisions in the CPI

Changes in the quality of goods in the market basket Over time, manufacturers improve the quality of products. Quality changes are not necessarily reflected in proportionate prices changes. For example, today's side-by-side frost-free refrigerator with automatic ice maker and ice crusher are a far cry from the ice box at the turn-of-the-century. Today's automobile with air conditioning, cruise control, steel-belted radial tires, built-in CD player with quadraphonic sound, and dual air bags is no comparison to even Henry Ford's popular Model T.

Changes in the composition of goods in the market basket Over time, people discard older, out-dated items from their market basket and update it with new products. For example, at some point, wooden wagon wheels got deleted and steel-belted radial tires added. The crystal radio was eventually replaced by SONY CD-Walkman and now an MP3 player. Similarly, today's average market basket includes a personal computer, a compact disk player, a VCRs, a cell phone, and an MP3 player, all unheard of 15-20 years ago.

Recent Revisions

The Census Bureau made several revisions in 1978, 1987, and 1992. The 1987 revision, in particular, made several major changes. Many factors contributed to the need for revision, including differences in consumer buying habits as well as prices, population shifts in age and location, new technology and products, and new category definitions.
  1. The new price index reflects the increased number of two-income families, singles' households, and elderly people as well as other demographic changes over the last nine years.

  2. It reflects more spending on physical fitness; eating out, especially in fast food restaurants; new products such as compact disk, stereo, and big screen TV equipment; the impact of energy conservation; and the population gains of the Sun Belt.

  3. It reflects the decline in consumption of red meat (and the increased popularity of poultry and fish); the decline in the demand for sugars and sweets, as a result of families with fewer children who are the biggest buyers; and a decline, for the same reason, in school lunches, while dinners away-from-home increased.

  4. Transportation expense dropped considerably as a result of lower fuel prices and more fuel-efficient vehicles.

  5. For the first time, in the 1987 revision, the service sector accounted for more than half of all spending, up 6 percentage points to 52% from 46% in the 1978 revision. Spending on commodities and goods has slipped to 48%. One implication of this trend is that wages, fees, and salaries will be the dominant influence on future inflation levels.
FAQs about the CPI, last modified on 28 Jun 2010
Common Misconceptions about the Consumer Price Index: Questions and Answers, last modified on 5 Sep 2008

Personal Consumption Expenditure Price Index

The Federal Reserve uses the Core Personal Consumption Expenditure Price Index (Core PCEPI) to monitor price stability — core inflation — rather than the Personal Consumption Expenditure Price Index (PCEPI) — headline inflation — for two primary reasons. First, the PCEPI eliminates many of the temporal problems of the CPI, because the PCEPI is a measure of prices for all consumer goods, regardless of who is buying them, and it updates automatically as new products come to market. A weakness of the PCEPI, like the CPI, is its inability to adjust for quality changes in products where a quality change is not adequately reflected in price. Second, the Core PCEPI eliminates the month-to-month "noise" created by temporary changes in food and energy prices.

top    IV. Causes of Price Instability

demandpullinflation
Demand-Pull Inflation

Demand-pull inflation is when increased spending pulls up prices faster than businesses can increase output. An increase in aggregate demand from AD0 to AD1 pulls up prices from P0 to P1 along AS. Competitive bidding for relatively scarce goods and services pulls up prices. If the economy is not at full-employment, demand-pull inflation increases output and reduces unemployment. At full employment increased spending results in pure inflation. The causes of demand-pull inflation are several:
  1. Consumers may dishoard past saving.

  2. Consumer credit may be too liberal.

  3. Government deficits may be too large.

  4. Commercial and bank credit may be excessive.

  5. Money supply may be increasing to rapidly.

  6. The dollar may be falling too fast.
costpushinflation
Cost-Push Inflation

Cost-push inflation is when increased costs of factor inputs in excess of productivity increases push up prices. Wages, material costs, capital, land, and interest expense increases are passed along to consumers via administered prices (monopolistic elements) and cost-plus or mark-up pricing.

w/p = MPL or p = w/MPL

ln(p) = ln(w) - ln (MPL)

d{ln(p)}/dt = d{ln(w)}/dt - d{ln(MPL)}/dt

%Δp = %Δw - %ΔMPL

A decrease in aggregate supply from AS0 to AS1 pushes up prices from P0 to P1 along AD. Cost-push inflation reduces output and increases unemployment.

demandpushdeflation
Demand-Pull Deflation

Demand-pull deflation is when decreased spending pulls down prices. A decrease in aggregate demand from AD0 to AD2 pulls down prices from P0 to P2 along AS. Deficient demand and competitive selling pressures combine to reduce the glut of goods and services by pulling down prices. If the economy is at full-employment, demand-pull deflation increases unemployment, as firms attempt to adjust inventories and production before prices. At higher rates of unemployment, decreased spending results in pure deflation. The causes are several:
  1. Consumers may increase saving.

  2. Consumer credit may be too restricted.

  3. Government surpluses may be too large.

  4. Commercial and bank credit may be tight.

  5. Money supply may be contracting or increasing too slowly.

  6. The dollar may be rising too fast.
costpulldeflation
Cost-Push Deflation

Cost-push deflation is when decreasing factor costs and/or changes in technology push down prices. Increased supply and competitive selling pressures combine to reduce the glut of goods and services by pushing down prices. An increase in aggregate supply from AS0 to AS2 pushes down prices from P0 to P2 along AD. Cost-push deflation increases output and reduces unemployment.

Structural Inflation

Structural inflation (bottleneck inflation) is when the general level of prices increases due to downward stickiness of prices in markets for which demand is declining while prices are increasing in markets where demand is increasing. Inflexibility and immobility among the factors of production and contracted factor costs permit prices to rise faster in industries where demand is increasing than they tend to fall in industries where demand is declining. Imperfect markets create a temporary bottleneck, until resources can be reallocated according to changing demands.

top    V. Consequences of Price Instability

Consequences of Inflation

Benefits debtors and those whose incomes depend on prices, e.g., labor (wage income), home owners, antique and art collectors. Debtors, in particular, gain because they repay cheaper dollars. They gain because they bought and financed at yesterday's lower prices and interest rates.

Hurts creditors and those on fixed incomes, e.g. lenders, bondholders, pensioners. Creditors receive cheaper dollars in repayment and cannot purchase the same amount of goods and services as before they made their loans. Pensioners, bond holders, and other fixed-income recipients lose purchasing power as prices rise, but income does not.

Distorts the pattern of resource usage Time is wasted moving resources between and among alternative uses, as some prices rise faster than others. Since inflation tends to redistribute purchasing power, inflation distorts relative demands, resource allocations, and the pattern of development. For example, a low interest rate, deflationary environment tends to promote the development of interest-sensitive sectors, such as automobiles and housing. When the movement reverses itself, the economy is left with overproduction and a waste of resources in the over-built sectors and not enough resources to expand production in the under-built sectors.

A little inflation (chronic inflation) may actually be good for an economy. It tends to promote economic growth by allowing prices and profits to rise faster than wage costs. Businesses are more willing to expand output in response to these profits.

Rapid inflation (hyperinflation) is bad for en economy. It forces a flight from money into physical goods. Hyperinflation generally terminates in a barter system and stagnation.

Consequences of Deflation

Benefits creditors and those on fixed incomes, e.g. lenders, bondholders, pensioners. As prices fall, the purchasing power of interest and principal repayments from lending and fixed income from pensions increases.

Hurts debtors and those whose incomes are tied to prices, e.g., labor (wage income), home owners, antique and art collectors. Debtors, in particular, repay debt in more expensive dollars and lose the opportunity to purchase goods and services at the lower prices.

Distorts the pattern of resource usage Time is wasted moving resources between and among alternative uses, as some prices fall faster than others.

A little deflation (chronic deflation) may actually be good for the economy. Falling prices increase purchasing power as prices tend to fall faster than wage income.

However, a deflationary environment is more threatening for the economy than inflation. Even though consumers like to see falling prices, the inability to raise prices depresses businessmen's expectations. Capital spending and wages fall. Rapid deflation cuts profits and firms respond by cutting production levels, laying off workers, and increasing the pool of unemployed. The end result is depression and stagnation.

top    VI. Optimum Amount of Price Stability

No one likes roller coaster prices. They tend to distort individuals' behavior patterns and the pattern of resource allocation. When prices swing widely, much time is wasted rearranging resource usage, only to find old patterns repeated. Except for relative shifts in prices in response to changing tastes and preferences and resource availability, the general level of prices should remain fairly stable. Such stability permits more accurate decisions concerning today's choices and tomorrow's opportunities. But, what exactly constitutes stability?

Price Stability

Alan Greenspan, former Chair of the Federal Reserve Board of Governors, said that price stability exists when inflation is not a consideration in household and business decisions. Unfortunately, this answer begs the question, because it fails to identify a target of any known achievable consequence. How does one know when inflation is not a consideration in household and business decisions? Take a survey? In different countries, at different times, the survey will yield different results. In some countries, households and businesses have lived very comfortably with double-digit rates of inflation. In others, the slightest hint of price rises causes households and businesses to rearrange their decisions. Therefore, policy makers need objective quantifiable measures of price stability to guide them in achieving this goal.

Price stability is when prices fluctuate within some socially acceptable range or narrow band. For example, a target of 0% ± 2% allows for prices to rise or fall by as much as 2% per annum, but no more. This plus-minus range implies, however, that the general level of prices is free to fall as well as rise and that a prolonged or severe deflation is just as bad as a prolonged or severe inflation.

Price Instability

Price instability is when prices fluctuate outside the socially acceptable range. In the above example, an inflation rate of 4% or a deflation rate of 3% is unacceptable and indicative of price instability.

While no policy maker has specifically identified an acceptable range, the consensus in 1946, at the time Congress passed the Employment Act, was that a minimum rate of unemployment of 4.0% could be sustained, if inflation were no greater than 2.0%. For most of the post-WW II period, the U.S. economy fought rising rates of inflation. Fifty years later, in the mid-1990s, the U.S. economy managed to achieve its benchmark. However, since the late 1990s, the U.S. economy has been flirting with deflation.

top    VII. Inflation Expecations

Calculating Inflation Expectations

This premium can be calculated by comparing the difference in yields on a Treasury and a TIP of similar maturity. The result indicates the amount of protection investors require, which in turn tells us their inflation expectations. For example, if the five-year Treasury has a yield of 3% and the five-year TIPS has a yield of 1%, then inflation expectations for the next five years are roughly 2% per year. Similarly, using two- or ten-year issues would tell us the expectation for those periods. This difference is often referred to as the "breakeven" inflation rate.

Another way to look at the equation is: Treasury yield = TIPS yield + expected inflation.

We can therefore easily find the market's expectation for the future inflation rate, in theory. The reason this is only "in theory" is because the differences between the two securities lead to market distortions that prevent this calculation from providing an exact result. Trading volume in TIPs is much lower than in Treasuries, so the yield differential can often change due to technical factors not having to do with inflation expectations. As a result, the yield gap can be used as a guide but not an absolute measure of current expectations.

top    VIII. Current Trends

Post World War II to Mid-1960s

In the period immediately following WW II, prices in the U.S. remained relatively stable. Neither inflation nor deflation plagued the economy. Throughout the 1950s, prices never rose by much more than 1.0% per year. This period of slowly rising prices gave rise to the concept of chronic inflation.

Mid-1960s to Early 1980s

In the mid-1960s, however, higher rates of inflation began to plague the economy. The period started with a demand-pull inflation spawned by increased government spending on both military efforts for the Vietnam War and social programs to build President Johnson's "Great Society." Once prices began to rise, the spiral was fueled, on the demand side, by inflationary expectations that kept current consumer spending buoyant in anticipation of tomorrow's higher prices, by low real interest rates and rates of return, in general, and by inflationary expectations that forced individuals to shift from financial assets into real assets (such as real estate, precious metals, and art). It was also fueled by a cost-push inflation, on the supply side, spawned by two successive increases in the price of oil (one in 1973; the other in 1979), by strong labor unions exacting wage increases in excess of productivity gains, by the introduction of cost of living adjustment (COLA) clauses in collective bargaining agreements (where COLAs not just followed, but also anticipated price increases), and by a weak dollar.

Early 1980s to Mid-1980s

The inflationary spiral of the 1970s peaked in 1981 at a 13.5% per annum increase in consumer prices and ended with two back-to-back recessions in the early 1980s. A tight monetary policy, engineered by the Federal Reserve, under the leadership of its Chair, Paul Volcker, helped to wring inflation out of the economy. Subsequently, disinflation set in and inflation rates trended downward. A primary reason for this early- to mid-1980s disinflation was a strengthening of the U.S. dollar. An increase in the value of the dollar makes imports cheaper. When imports are relatively cheap, U.S. businesses have a harder time raising their own prices. Thus, the rate of inflation decreases.

Mid-1980s

In 1986, the CPI rose by only 1.9%, the smallest annual increase since a annual rise of only .7% in 1961. In some respects this rate was an anomaly, because it was due solely to falling oil prices. The core rate of inflation for the year was 4.0%. During this period, Iran and Iraq were at war. When it appeared that Iran might win the war, Saudi Arabia, who despised the political regime of its religious leader, the Ayatollah Kouhmeni, flooded the market with oil to purposefully depress oil prices and deprive Iran of revenues. Once the threat of Iran's success abated, Saudi Arabia cut back its production and sale of oil on the international market and oil prices rose to their previous levels. The inflation rate of 3.7% in 1987 partly reflects this rise in the price of oil.

Mid-1980s to 1990

After 1986, prices began to rise at a more rapid rate for five primary reasons.
  1. A decline in the value of the dollar In September 1985, the Group of Five (Great Britain, France, Germany, Japan, and the United States) met and mutually agreed to engineer the decline (the Plaza Accord). A decrease in the value of the dollar makes imports more expensive. When imports are more expensive, U.S. businesses have more leeway to raise prices on their own goods and services. Thus, the rate of inflation increases.

  2. An increase in oil prices OPEC members settled their differences and agreed on a new higher price for oil.

  3. An increase in the prices for other non-oil commodities Climatic changes over the period adversely influenced commodities outputs and their prices. Commodities price changes work their way through the production process to goods and reach the consumer approximately 6-12 months later.

  4. Lack of excess capacity The flashpoint for an increase in the rate of inflation is an aggregate capacity utilization rate of 85%. By the end of 1988, the U.S. rate had reached 85.1%, the highest rate since December 1978, when factories were functioning at an 86.9% rate. Capacity utilization for durable goods stood at 83.5%, while the rate for nondurable goods reached 86.9%. Some basic materials producers were operating at even higher rates: paper and paper products, 94.6%; primary metals, 91.6%; textiles, 90.6%; chemicals, 89.2%; petroleum products, 89.1%; and rubber and plastics, 88.5%. These above-optimum rates increased inflation and concerns about further increases.

  5. An increase in inflationary expectations Americans believed that the inflation of the 1970s was not completely under control and they began to act and make spending/saving decisions as though the rate of inflation would increase.
The 1990s and Beyond

Headline inflation and core inflation rates peaked in 1990 at annual rates of 5.4% and 5.0%, respectively. Since then, both rates of inflation have trended downward. Since 1992, the headline inflation rate has stayed below 5.0%, with most years averaging between 2.0% and 4.0%. The core inflation rate has remained below the 3.0% rate since 1994. By all indicators, the U.S. economy appears to have entered a period of relative price stability.

The following ten (10) factors are expected to keep inflation rates low for the foreseeable future:
  1. A weakened OPEC The OPEC organization is not so strong as it was in the 1970s. In fact, OPEC has disintegrated in all but its name. Differences among members regarding quotas and revenues keep the organization from achieving its stated goals. First of all, Saudi Arabia, the marginal producer, is less willing to restrict its output and revenue for the benefit of other members, especially Iran. Second, the Arab ethnic bond is not so strong as it once was, given increasing differences among Arabs over relationships with Israel. Third, some of the member countries, especially Nigeria, have large foreign debts to repay and have cheated to gain revenue at the expense of other members. Fourth, non-OPEC countries, like Mexico, have also been anxious to export oil at lower prices to gain revenue for debt repayment. Finally, the North Sea explorations of the 1970s and the completion of the Alaskan pipeline have resulted in increased supplies of non-OPEC oil. Energy shocks, like those of the 1970s, are not so likely to occur in the near future, given the size of the surplus that now exists.

  2. Energy conservation Energy conservation on the part of industrialized countries has dampened the demand for oil since 1990. However, oil prices rose very rapidly in the mid-2000s due to increasing demand for oil by the developing countries of India and China. The price of West Texas Crude rose to $150 per barrel in summer 2007, and the price might have gone higher, but for the world-wide recession that began in Fall 2007. The increased oil prices pushed the U.S. headline inflation rate to a peak of 5.6% in July 2008. However, oil prices and the U.S. inflation rate have subsequently fallen because of the world-wide recession. Oil Price History and Analysis

  3. Domestic excess capacity As it turned out, capacity utilization peaked at 85.2% in January 1989. Thereafter, it fell to a low of 78.7% during the 1990-1991 downturn, rose to a high of 85.0% in January 1995, fell to a low of 73.6% following the 2001 downturn, reached a peak of 81.6% in 2007, dropped to 68.2% in 2009, and has recovered to only 74.1% as of mid-2010. The U.S. economy has operated well blow its inflationary capacity utilization flashpoint since the late 1980s.

  4. Rolling stock expansions One reason why the U.S. economy has not reached its inflationary capacity utilization flashpoint is because not all industries reach capacity limits at the same time. As individual industries reached capacity, their firms added to their capital stock. This gradual increase in capital kept the average rate of capacity utilization from rising as rapidly as during other expansionary periods and allowed for a more orderly progression of capital formation that should keep the lid on inflation in the coming years.

  5. Worldwide excess capacity Most commodities are in excess supply. In the mid-1970s, there were a world-wide shortages of several key commodities, like oil and sugar, and their prices soared. Currently, neither oil nor sugar nor any other basic raw material is in short supply and the prices on most of these basic commodities, even though they had risen since the mid-1980s, remained at or near historic lows.

  6. Stable commodities prices Commodities prices as measured by the CRB Commodities Price Index fluctuated in a narrow range throughout the 1980s and 1990s. The Index has been more volatile in the 2000s. However, for each wild increase in the Index, it has had a wild decrease, so that commodities prices were little changed at the end of the decade from the beginning of the decade.

  7. Limited wage gains Labor accounts for over 60% of all production costs, so that even small changes in the employment cost index have big ramifications for final prices. Since 1981, the employment cost index has slowly but steadily declined. Wage and compensation gains slowed to 3.1% in 1987, compared with 12% in 1981. Subsequently, they rose to a rate of gain of 4.9% in 1990, but these gains abated to a rate of approximately 2.5% per year in the 1990s and to barely 1.0% in the 2000s. Labor's position has been much weakened as a result of changes in technology and increased competition from foreign products. In 1974, the BLS reported 424 work stoppages of 1000 or more workers. In 1986, that number dropped to 69 and, since 2005, the number has averaged less than 20 per year. In 1976, COLA clauses were found in 61% of all labor contracts. By 1985, the number had dropped to 49% and, by 1986, to 40%. By the end of 1995, when the U.S. Bureau of Labor Statistics stopped collecting data on collective bargaining settlements, COLA coverage had fallen to 22%. Many unions have been forced into wage freezes and concessions. Much of the "wage push" element of the 1970's inflation has dissipated.

  8. Outsourcing Many domestic firms have taken to "outsourcing" — sending production to labor-cheap foreign countries and buying parts that they once manufactured themselves from non-union shops in the US. and abroad. Outsourcing is an important way of alleviating restraints on domestic productivity and of keeping resale prices low.

  9. Over-leveraged consumers Consumers are highly leveraged. By the end of 1986, consumer installment debt had reached a record high 20% of personal income. The consumer installment debt ratio fell to 15.3% by 1992, but increased steadily thereafter. The ratio once again peaked in 2008 at 22.1%. Although the consumer installment debt ratio has fallen to 18.6% in the last two years, consumers still remain overly extended with mortgage debt. When mortgage debt is added to consumer installment debt, the income ratio is over 100%. Consumer cCredit

    In the mid-2000s, banks started making subprime, Alt-A, and jumbo mortgage loans on variable rate terms to people who could not afford them. When the rates reset to higher rates in 2007, many mortgagors defaulted. Then, housing prices fell and many homes went "under water," meaning that their sale price was less than the balance on the mortgage. These mortgagors defaulted. Finally, as a result of the economic downturn, many people who have lost their jobs and cannot afford to keep up their mortgage payments have defaulted. Mortgage Debt Outstanding

    In the last two years, since 2007, banks and other lenders have tightened credit standards. As a result of overextended indebtedness and tightened credit standards, demand-pull inflation from the household sector is rather unlikely. Moreover, individuals periodically try to buy down debt rather than increase debt-financed purchases, unless the banks and credit card companies loosen their credit standards and expand credit lines. Household Debt Service and Financial Obligations Ratios

  10. A stable exchange rate for the U.S. dollar The value of the U.S. dollar stabilized and even rose 10%-20% from its lowest value against the currencies of its major trading partners. It continued to rise until the end of 2002. The value of the dollar fell from the end of 2002 to the end of 2008, but the decline was not so steep as the rise from the mid 1980s to the end of 2002. In 2009 and 2010, the value of the dollar has whipsawed. It increased by 20% in early 2009 and then fell by 10.0% in late 2009. It appears to be relatively stable in 2010.

  11. Favorable trade agreements Several conferences under General Agreement on Tariffs and Trade (GATT), which reduced trade barriers, and the passage of the North American Free Trade Agreement (NAFTA), which eliminated all trade barriers among Mexico, Canada, and the United States, have kept import prices from rising.

  12. The down-side of a long wave Most world economies are past the peak of a long wave. This means that deflation will be more of a problem than inflation. After each recession (depression?) on the downside of a long wave, prices and interest rates tend to rise. However, each rise peaks at a rate below the prior peak. The U.S. experienced such a rise in inflation and interest rates from 1986 to 1990. Starting with the 1990-1991 recession, both rates trended down again. Currently, the U.S. is experiencing its longest sustained period of low inflation and low interest rates. If the first quarter of 1997 is any indicator of the future, the inflation rate for the entire year could well be below 2.0%, and interest rates, as measured by the rate on the U.S. government's 30-year bond, should stay below the critical 7.0% mark.

  13. A cautious Federal Reserve The Federal Reserve, under the leadership of its former Chair, Alan Greenspan, was extremely cautious. Mr. Greenspan was not an ideologue, but rather a pragmatist. The Federal Open Market Committee (FOMC), the official policy-making "arm" of the Federal Reserve, has adopted this pragmatic philosophy in its approach to setting monetary policy. It watches neither the rate of growth of the money supply (a Monetarist philosophy) nor interest rates (a Keynesian philosophy). Instead, it has focused on the entire economy for signs of increased inflation. When such signs have appeared, the FOMC has acted promptly to raise interest rates by one-quarter of a percentage point (or 25 basis points). On a few occasions, the FOMC has acted preemptively to thwart pending increases, even though the business community disagreed with such moves. If the Greenspan tenure is remembered for one thing, it will be the "nudging" of interest rates up and down by a quarter of a percentage point each time it acted.

    On February 1, 2006, Ben Bernanke replaced Alan Greenspan on the Board of Governors and became the new Chair. Bernanke's FOMC continued in the footsteps of the Greenspan FOMC. However, less than two years into his tenure, Bernanke was faced with what turned out to be a major financial crisis. Bernanke had to act quickly and be innovative. In the process, the Federal Reserve's balance sheet grew from $869 billion in assets to $2.3 trillion. Now, the Federal Reserve's great concern is walking a tight rope. On the one hand, the Federal Reserve needs to prevent a major inflation, if the banks decide to lend their billions of dollars in excess reserves and unexpectedly expand the money supply. On the other hand, the Federal Reserve needs to unwind its asset positions without engineering a double dip recssion.
top    Summary

Price stability is measured as the annual or annualized percentage change in the general level of prices. The general level of prices may be measured with several different price indexes: the Consumer Price Index (CPI), the Core Consumer Price Index (CCPI), the Personal Consumption Expenditure Price Index (PCEPI), the Core Personal Consumption Expenditure Price Index (CPCEPI), the Producer Price Index (PPI), the Core Producer Price Index (CPPI), the Employment Cost Index (ECI), and the Implicit GDP Price Deflator. Selection of a particular index depends upon the type of price stability to be measured and the use to which the measure is put. The Federal Reserve monitors the Core PCEPI for monetary policy purposes.

Prices can be unstable, either because changes in demand are pulling them up (demand-pull inflation) or down (demand-pull deflation) or because costs, changes in technology, and the foreign exchange rate of the dollar are pushing them up (cost-push inflation) or down (cost-push deflation). Bottleneck inflation occurs when prices on some products for which demand is increasing rise while other prices where demand is decreasing are slow to fall.

A little price instability is generally to be expected in a dynamic economy However, price instability outside some acceptable bounds — whether inflation or deflation — negatively affects economic participants and distorts resource allocations. Inflation benefits debtors and those whose incomes depend on prices and huts creditors and those on fixed incomes. Deflation benefits creditors and those on fixed incomes and hurts debtors and those whose incomes are tied to prices.

Alan Greenspan, former Chair of the Federal Reserve Board of Governors, said that price stability exists when inflation is not a consideration in household and business decisions. An approriate quanitative bound, however, depends upon the economic culture and its historical past. The Federal Reserve is currently tareting a 0.%-2.0% range for changes in the Core PCEPI for monetary policy purposes. It has been relatively successful since the early 1990s. Some of the success has been due to energy conserveration and a weakened OPEC, some has been due to worldwide excess capacity, some has been due to weak resource prices, some to weakened labor demands, some to a strong dollar, some to softened demand from too much debt, and some to a cautious, but innovative Federal Reserve.

top    Readings

The New Inflation: Causes, Effects, Cures, G.L. Bach, Prentice-Hall, Englewood Cliffs, NJ, 1972

Inflation: Money, Jobs, Politicians (Policies and Performance: Nixon through Carter), Raburn M. Williams, Arlington Heights, IL: AHM Publishing Co., 1980

Inflation Expectations and Money Growth In the United States, Donald J. Mullineaux, American Economic Review, LXX(1) Mar 1980: 149-61

Fiscal Policies, Inflation, and Capital Formation, Martin Feldstein, American Economic Review, LXX(4) Sep 1980: 636-50

Supply-side Inflationism, Leland B. Yeager, Policy Report (Cato Institute), VII(6) Jul/Aug 1984: 1-6

The Rigidity of Prices, Dennis W. Carlton, American Economic Review, LXXVI(4) Sep 1986: 637-58

Commodity Prices and Inflation, Fred Furlong and Robert Ingenito, Economic Review, (FRBSF), 1996(2)

The Costs and Benefits of Price Stability: An Assessment of Howitt's Rule, Daniel L. Thornton, Review (FRBStL), 78(2) Mar/Apr 1996, with data files

Inflation Targets: The Next Step for Monetary Policy, Mark S. Sniderman, Economic Commentary (FRBClev), 1 Aug 1996

Inflation Targeting, Chan Huh, Economic Letter (FRBSF), 97(4) 7 Feb 1997

Maintaining a Low Inflation Environment Has Come, John B. Carlson, Economic Commentary (FRBClev), 1 Mar 1997

Are There Good Alternatives to the CPI? Charles Steindel, Current Issues in Economics and Finance (FRBNY). 3(6) Apr 1997

Should Monetary Policy Focus on "Core" Inflation? Brian Motley, Economic Letter (FRBSF), 97(11) 18 Apr 1997

Bias in the CPI: 'Roughly Right or Precisely Wrong' Brian Motley, Economic Letter (FRBSF), 97(16) 23 May 1997

The Commission Report on the Consumer Price Index: Commentary, Griliches, Zvi, Review (FRBStL), 79(3) May/Jun 1997

Inflation Measurement and Inflation Targets: The UK Experience, William A. Allen, Review (FRBStL), 79(3) May/Jun 1997

Measuring Short-Run Inflation for Central Bankers, Stephen G. Cecchetti, Review (FRBStL), 79(3) May/Jun 1997, with Commentary, by Alan S. Blinder, and Commentary, by Mark A. Wynne

Quality Change in the CPI, Charles R. Hulten, Review (FRBStL), 79(3) May/Jun 1997, with Commentary, by Per Krusell and Commentary, by Robert J. Gordon

A Bureau of Labor Statistics Prespective on Bias in the Consumer Price Index, John S. Greenlees, Review (FRBStL), 79(3) May/Jun 1997

On Defining Real Consumption, Edward C. Prescott, Review (FRBStL), 79(3) May/Jun 1997

Alternative Strategies for Aggregating Prices in the Consumer Price Index, Matthew D. Shapiro and David W. Wilcox, Review (FRBStL), 79(3) May/Jun 1997, with Commentary, by W. Erwin Diewert, and Commentary, by Peter Howitt

Wage Inflation and Worker Uncertainty, Mark E. Schweitzer, Economic Commentary (FRBClev). 15 Aug 1997

Inflation Targeting: Lessons from Four Countries, Frederic S. Mishkin and Adam S. Posen, Economic Policy Review (FRBNY), 3(3) Aug 1997

A Framework for the Pursuit of Price Stability, William J. McDonough, Economic Policy Review (FRBNY), 3(3) Aug 1997

What is the Optimal Rate of Inflation? Carl E. Walsh, Economic Letter (FRBSF), 97(27) 12 Sep 1997

What is the Optimal Rate of Inflation? Timothy Cogley, Economic Letter (FRBSF), 97(27) 19 Sep 1997

On the Origin and Evolution of the Word Inflation, Michael F. Bryan, Economic Commentary (FRBClev), 15 Oct 1997

Is There an Inflation Puzzle? Cara S. Lown and Robert Rich, Economic Policy Review (FRBNY), 3(4) Dec 1997

Problems of Price Measurement, Alan Greenspan, Annual Meeting of the American Economic Association and the American Finance Association, Chicago, IL, 3 Jan 1998

Economic Forecasting, Laurence H. Meyer, Downtown Economics Club 50th Anniversary Dinner, New York, NY, 3 Jun 1998

Canada's Money Targeting Experiment, Paul Gomme, Economic Commentary (FRBClev), 1 Feb 1998

Inflation Targeting, Edward M. Gramlich, Charlotte Economics Club, Charlotte, NC, 13 Jan 2000

Greenspan Rejects Idea of Inflation Target, Bloomberg News, New York Times, 12 Oct 2001

The Historical and Recent Behavior of Goods and Services Inflation, Richard W. Peach, Robert Rich, and Alexis Antoniades, Economic Policy Review (FRBNY), forthcoming

top    Websites

Consumer Price Index, BLS, current
Consumer Price Indexes, BLS, current and historical series
Announcement to Users of CPI Data, re: Revisions in the CPI, BLS
Monthly Consumer Prices Indexes, FRBStL (FRED), historical series
Prices, FRBDal (Source: BLS), charts and historical series of CPI, PPI, and Implicit GDP Deflator


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