Economist Milton Friedman famously said that “inflation is always and everywhere a monetary phenomenon.” The more money that is circulating in an economy chasing limited goods and services, the higher inflation is likely to be.
Inflation measures the rate of rising prices of goods and services in our economy. Another way to view inflation is a decline in money’s purchasing power over time: Because of rising prices, a dollar buys fewer goods and services than it did previously.
Further, inflation acts as a tax on wages and investments. As inflation increases, the purchasing power from one’s wages or investment returns declines. For borrowers, however, inflation can be a benefit, as debtors pay back their loans with future dollars that have less value than when the loan began. Hence, everyone should be concerned about the level of inflation in the economy and the role that government plays in affecting prices though fiscal and monetary policy.
Moderate, stable inflation is indicative of a healthy economy. As the economy grows, consumer demand increases, causing businesses to respond with increased labor needs and relatively higher prices to meet excess demand. In fact, the Federal Reserve sets a long-term inflation target of 2% and has several tools at its disposal to try to keep price levels under control.
Two main indices measure inflation: the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) price index.
- Consumer Price Index (CPI): Produced monthly by the Bureau of Labor Statistics (BLS), the CPI measures consumer price changes for all urban consumers, accounting for most of the U.S. population. Each month, the CPI’s fixed “basket” is constructed using 80,000 household goods and services, including food, clothing, shelter, transportation, and medical services. Through surveys administered to households across the country, BLS assigns a weight to each item dependent on its relative importance to the average consumer. BLS then aggregates the price changes for these individual items to calculate overall inflation.
- Personal Consumption Expenditures (PCE): Produced monthly by the Bureau of Economic Analysis, the PCE price index is the primary measure of inflation used by the Federal Reserve. Whereas the CPI primarily relies on consumer surveys to determine the relative weights of various expenditures, the PCE price index assigns weights using business surveys, leading to an alternative composition of goods and services in the basket. It also accounts for substitutions between goods by adjusting weights accordingly when one becomes relatively more expensive. Finally, the PCE price index has a slightly wider scope than the CPI: While the CPI measures changes in expenditures for urban consumers, the PCE price index measures price changes for all consumers, as well as nonprofits and government programs that serve households.
Both measures also have “core” indices that exclude the food and energy industries given their price volatility. Some policymakers, such as the Federal Reserve, use core inflation to predict inflation because food and energy price volatility can make it difficult to discern trends from the overall inflation rate.
The CPI recorded a 5.4% year-over-year jump in both June and July, a level of inflation not seen since 2008. In June alone, prices rose 0.9%, and then spiked an additional 0.5% in July. The PCE price index for July 2021 rose 4.2% from the prior year, following a 4.0% year-over-year increase in June.
The overall increase in prices can be attributed to the country’s economic recovery over the past months, as the labor market continues to rebound and consumers are beginning to spend at their pre-pandemic levels. Suppliers, however, have not been able to adjust their production capabilities and supply chains to meet the sudden change in consumer behavior. With demand outpacing supply, the result has been widespread price increases. Historically low interest rates have also made it easier for consumers to borrow and spend, fueling this trend.
Economists are attributing rising overall inflation to those sectors that were relatively dormant through the pandemic and that are now bouncing back as consumer demand and spending accelerate. The transportation and travel sectors have been particularly emblematic of this trend. For example, prices for used cars shot up 41.7% in the past 12 months—with a 10.5% increase in June alone—but are starting to plateau, with only a 0.2% increase in July. This surge reflects both strong consumer demand and a shortage of computer chips needed to build more cars. Gas prices have notably skyrocketed as people travel more, increasing 41.8% in the past 12 months, and airfares are up 19.0% over the same period.
Many of these price increases are expected to recede once supply catches up with demand and spending habits normalize. In fact, July may have provided a preview of this pattern: The month’s 0.5% increase in prices was the smallest month-over-month change since February. Prices for used cars barely increased, and airfare prices decreased.
The short answer: It’s unclear. At this early stage in the nation’s economic recovery, it is difficult to predict whether the inflation we are experiencing now is transitory or persistent.
Those who view today’s inflation as transitory contend that current price spikes are tied to recovery efforts and temporary supply shortages, and that this summer surge in spending will eventually stabilize. Their take is that supply will ramp back up as employment increases and companies adjust production to meet demand. The Biden administration endorses this view and attributes inflation to temporary growing pains as the economy normalizes, with inflation projections of 4.8% in the fourth quarter of 2021 over prior year, before dropping to 2.5% in 2022 and stabilizing at 2.3% through 2031. Economists who are less concerned about the current rise in prices further assert that many consumers are not personally facing price increases as dramatic as top-line inflation rates suggest, as price increases are concentrated in selected markets and not evenly spread across the economy.
Those who anticipate persistent inflation assert that the recent wave of expansionary fiscal and monetary policies has injected an unsustainable amount of liquidity into the economy, enabling consumers to spend at rates that will continue exceeding production capabilities (i.e., demand will continue to outstrip supply). Increased demand for workers has also boosted wages, which are unlikely to fall in the short-term. This could itself spur inflation as businesses charge more for products to cover increased labor costs. Further, continued labor shortages signal that production could remain stagnant.
The Federal Reserve’s dual mandate stipulates that it keep unemployment low and prices stable. To bring inflation down it can increase interest rates, or the cost of borrowing, which also has the effect of slowing economic activity. Another option available is to cool the overheating housing market by beginning to taper the Federal Reserve’s $120 billion in monthly purchases of Treasury and mortgage-backed securities. Given that the American economy is still in the early stages of recovering from the COVID-19 recession, Chairman Jerome Powell has said that rates will remain low in the near term. This could mean that inflation still has some room to run before the Federal Reserve plans to take any significant steps to curb it.
Legislators are generally limited in their ability to control inflation. Nonetheless, fiscal policy, especially setting tax rates and levels of public spending, can impact consumer decisions and the levels of supply and demand that influence inflation.
Not surprisingly, lawmakers have divergent views on inflationary risks and the optimal policy response. President Biden and many congressional Democrats see the president’s nearly $6 trillion economic agenda—including policies enacted under the American Rescue Plan of 2021 and pending investments in infrastructure, child and elder care, rental housing, and more—to be essential for a robust recovery. On the other hand, many congressional Republicans are skeptical of these proposals, and are concerned that further government spending will only increase demand and maintain elevated inflation levels. They argue for curtailing government spending to limit the amount of money circulating in the economy.
Only time will tell whether inflation proves to be transitory or persistent. Consumers will, however, face ongoing elevated prices in the short term as the economy continues to recover and grapple with the potential impacts of COVID-19 variants. As long as inflation remains top of mind for Americans, policymakers will be pressed to respond.