Academic journal article Economic Commentary (Cleveland)

Inflation, Inflation Expectations, and Monetary Policy

Academic journal article Economic Commentary (Cleveland)

Inflation, Inflation Expectations, and Monetary Policy

Article excerpt

The Federal Open Market Committee, or FOMC, decided to keep the federal funds rate target unchanged at its last meeting on August 8. Although I cannot speak for any of my colleagues on the Committee, two factors were behind my decision to support a pause at that meeting.

First, while the elevated inflation numbers concerned me, and indeed they still do, the overall pace of economic activity-especially housing activity-had begun to moderate, and the full effect of the FOMC's previous rate increases had not yet been felt. I viewed a pause as appropriate because I wanted the chance to accumulate more information before judging whether additional policy firming would be needed.

Another important element in my thinking was the stability of inflation expectations. I will quote directly from the minutes of the August 8 meeting here: "Following 17 consecutive policy firming actions, members generally saw limited risk in deferring further policy tightening that might prove necessary, as long as inflation expectations remained contained."

Why should inflation expectations matter so much to the FOMC? Congress has mandated that the Federal Reserve control inflation, of course, but also that it promote maximum sustainable growth. And it so happens that when inflation expectations are managed well-specifically, when they are anchored, the central bank-the Federal Reserve-can best promote sustainable economic growth.

The Difference between Inflation and a Relative Price Increase

Let me begin by making a crucial distinction between inflation and a relative price increase. People often see price increases in some of the items they buy and assume that a period of inflation has begun. However, inflation is a condition that affects all prices, not just the price of particular goods or services.

Consider copper prices. As of yesterday, copper prices were roughly seven times higher than they were in 1965.1 might conclude that the cost of obtaining copper is now seven times higher than it was 40-some years ago. But we all know that's not true.

The truth is that, despite large swings up and down, the relative price of copper-that is, its price relative to the average of all prices, based on the Consumer Price Index-tended to fall for much of the period from the mid-1970s through 2001. Over the past several years, the relative price of copper has shot up, of course, but even with this sharp increase, the relative price is nowhere near seven times its 1965 level.

Copper prices have not risen that much more than all prices, on average. The fact is that all prices, on average, have risen fivefold in the past 40 years. This fivefold increase in all prices is inflation.

A relative price increase is quite different from inflation. Changes in relative prices reflect changes in the supply and demand conditions of specific markets. Inflation reflects something else altogether.

It's true that the two are not always so easy to tell apart. Sometimes, we experience such a large and persistent relative price change that it temporarily ripples through the inflation data. The obvious example is energy prices.

Today, energy prices are greatly increasing the costs faced by virtually every business and household in our country. Purchasing the same amount of gasoline or heating oil as we did a couple of years ago requires us either to earn more, save less, or purchase fewer nonenergy items. Adjusting to higher energy prices requires us to make real sacrifices. The Federal Reserve cannot offset these costs because we do not create oil.

Nevertheless, the Federal Reserve can control inflation over the medium to longer term. While we can't increase the supply of oil, we do control the supply of money. And that means we control the average price level over time. To paraphrase a famous economist, Irving Fisher, the average price level doesn't rise because of the goods; it rises because of the money. …

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