Higher and higher inflation may seem relentless, but what exactly is driving it and what can be done? Government officials and the media are abuzz with talk of things like core inflation, supply chain problems, and interest rate hikes, but these terms can be opaque, to say the least.
As prices rise faster than they have since 1982, here’s how to translate the jargon.
Inflation is a sustained increase in the average price level of goods and services. While prices of individual products—gasoline or steak, for example—can go up or down, that doesn’t necessarily mean there’s inflation, because inflation is a broad increase in prices.
The speed at which prices increase is called the inflation rate, and that accelerated to 7% in December from 6.8% in November, according to the latest reading of one widely used measurement, the Consumer Price Index (see definition below). In other words, overall, prices in December were 7% higher than they were in December 2020. For context, the inflation rate has stayed around or below 3% most years since the early 1990s, and the last time it was this high was all the way back in 1982.
Because prices are rising much faster than usual, everyone from the general public to experts and leaders in business and government are trying to figure out how long it will last and what to do about it.
Inflation happens when “too much money chases too few goods,” according to an old saying in economics. There’s broad debate over exactly what is causing the current inflation trend. But some economists argue the pandemic’s shutdowns and labor shortages have caused difficulties in production and transportation that have given us the “too few goods” part of the equation, while government stimulus measures to combat the pandemic’s economic downturn have provided the “too much money” element.
As for what can be done about it, the government, via the Federal Reserve, can pull on its “too much money” lever and reduce its support, including by raising the cost of borrowing, which it’s now planning to do. But raising the Fed’s benchmark interest rate (see below) risks higher unemployment and hitting the brakes on economic growth, so it’s not always an easy choice.
CPI and PCE
The Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) price index are both government measures of consumer prices. The change in them, more often than not measured year-over-year, is inflation when it’s going up, and deflation when it’s going down.
With each index, there is a “headline” inflation rate as well as a “core” inflation rate (see definition below) that strips out prices from the volatile food and energy sectors. The details of how they measure price changes and what they measure are different, and explain why CPI tends to reflect more inflation than PCE.
CPI, released by the Bureau of Labor Statistics, measures how much urban consumers pay for a basket of goods and services based on household surveys. The basket is static, measuring the price changes of the same basket each month, and only accounts for out-of-pocket expenses so items that are not directly paid for—like Medicare or Medicaid—aren’t counted.
In contrast, the Bureau of Economic Analysis’s PCE index reflects the prices of goods and services businesses are selling. It includes those items not directly paid for by consumers, like medical care paid for by employer-provided insurance, and accounts for changing consumer choices, making the basket more variable. For example, if bread gets too expensive and people stop buying it, the weighting of bread drops in the calculation.
Though the government uses CPI to calculate changes to benefits such as Social Security, the Federal Reserve places more emphasis on the PCE index in determining monetary policy. The Fed favors PCE for three reasons: its flexibility to account for substitutions, its more comprehensive coverage of goods and services, and the ability for PCE historical data to be revised extensively compared with the CPI, which is revised only for seasonal adjustments.
Core Inflation Rate
The core inflation rate is a measure of inflation that excludes food and energy costs. While these items are obviously an important part of a household’s budget, they tend to rise and fall dramatically and often. As a result, experts closely study “core” inflation rates for more stable items to get a better idea of long-term trends, an especially important consideration for government policymakers. In the government’s latest CPI report, “core” inflation accelerated to 5.5% from 4.9% in November.
COLA stands for “cost of living adjustment,” which is when Social Security and Supplemental Security Income payments are hiked so that recipients won’t see the purchasing power (see definition below) of their benefits eroded by inflation. These payments will be increased 5.9% starting in January, the highest COLA in four decades, the Social Security Administration announced last week. For the average retired beneficiary, that’s an average boost of $92 a month.
Purchasing power means how much you can buy, which is determined both by how much money you have and by how much stuff costs. One way of measuring purchasing power is the government’s “real earnings” statistic, which compares wage growth with price increases.
Workers are in high demand these days, and they’ve been getting such big raises that their purchasing power has actually increased the last two months, even as higher inflation has made their dollars worth less and less.
The Federal Reserve aims for inflation of around 2% on average, over time. Fed Chairman Jerome Powell has said the central bank can overlook temporary or “transitory” swings in inflation, but as inflation has continued to soar, he’s said “transitory” is probably not the best term to describe it.
One tool the Fed has to control inflation is raising the benchmark interest rate, known as the fed funds rate, and officials now anticipate doing that this year. The benchmark rate influences a wide array of other interest rates, like those on mortgages and credit cards. If interest rates go up, it becomes more expensive to borrow money to purchase things, so demand for goods and services should go down. That, in turn, can reduce inflation.
The supply chain is the entire process of producing and transporting goods, from raw materials to factories to your front door or shopping cart.
When the supply chain gets clogged up somewhere along the way—for example, at a port that can’t unload cargo ships fast enough—a “bottleneck” is created, and whatever’s stuck on the wrong side of the bottleneck can become more scarce and expensive on the other side, contributing to higher inflation. Economists currently see pandemic-created bottlenecks everywhere, from homebuilding and heating oil to car manufacturing.
Stagflation is used to describe an economy that’s experiencing high inflation, high unemployment, and slowing economic growth, all at the same time. It’s unusual because inflation is supposed to occur when unemployment is low and the economy is growing. Whether the U.S. economy is entering a period of stagflation has been hotly debated lately, with the labor market and economy losing momentum even as this year’s inflation spike is forecast to last longer than expected.
Update - Jan. 12, 2022: This story was originally published on Oct. 19, 2021, and updated on Jan. 12, 2022.