Inflation has been a hot topic since 2021, but its causes, solutions, and broader implications remain unclear to many. So let's clear up some common misconceptions:
What is inflation?
Inflation is the rate of price increases for goods and services in an economy, primarily measured by the Consumer Price Index (CPI) and the Personal Consumption Expenditures Price Index (PCE). While the CPI gets more attention, the PCE is the Federal Reserve's preferred measure, differing mainly in the weight given to various categories.
However, these indices only provide general trends; individual experiences vary based on personal consumption habits. For instance, housing costs significantly impact both indices, but homeowners with low mortgage rates won't feel the effect of this category. On the other hand, if you consume a lot of eggs, you've definitely felt it in your spending.
What causes inflation?
Inflation can stem from several sources: demand-pull (e.g., Millennials buying houses), cost-push (e.g., COVID-19 supply chain disruptions), monetary policy (e.g., Quantitative Easing), and fiscal policy (e.g., stimulus checks and tax cuts). Typically, there is a combination of these factors at play, but primary drivers are a common debate among economists.
If inflation has come down, why are prices still high?
As inflation has moderated recently, people still complain about high prices, mistakenly thinking lower inflation means lower prices. In reality, lower inflation only means the rate of price increases has slowed.
If prices were to decrease overall (i.e. go back to 2019 levels), it would indicate deflation, which is harmful to the economy. Deflation suggests reduced demand and economic stagnation, creating a vicious cycle where expectations of lower future prices further decrease demand and shrink the economy.
Is inflation always bad?
Contrary to popular belief, inflation isn't always bad. Before 2020, the Federal Reserve was more concerned about deflation, with nearly a decade of inflation below the 2% target, leading to prolonged low-interest rates. While low rates benefit borrowers and stimulate economic activity, they also encourage speculative investments and limit future stimulus options through rate cuts.
What is the natural rate of interest?
The natural rate of interest, or r-star (r*), is the rate that neither stimulates nor restricts the economy. The Federal Reserve adjusts the federal funds rate (FFR) above or below this natural rate to control inflation or boost the economy, respectively.
However, the natural rate can't be calculated or observed in real-time, only estimated after the fact. This uncertainty complicates the Federal Reserve's task. If the Fed overestimates the natural rate, it may keep rates too high, stifling economic activity. Conversely, underestimating it could lead to premature rate cuts, exacerbating inflation.