Inflation: Is It Here to Stay?

Two main indices measure inflation: the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) price index.

1. 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.
2. 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. 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 6.2% year-over-year increase in October, the largest 12-month increase since November 1990. In October alone, the CPI surged 0.9%, more than double September’s 0.4% increase. In September, the PCE price index continued its upward trend, notching a 4.4% year-over-year increase.

The overall increase in prices can be attributed to the country’s economic recovery, as the labor market continues to rebound, and consumers are spending on many goods at above their pre-pandemic levels. Suppliers, however, have not been able to adjust their production capabilities and supply chains to meet the change in consumer behavior. For example, as of October, the trucking industry was 80,000 drivers short, which has contributed to the backlog at U.S. ports. A global shortage of semiconductor chips has disrupted the production of goods ranging from cars to laptops to refrigerators. With demand outpacing supply throughout the economy, the result has been widespread price increases. Moreover, low interest rates have made it easier for consumers to borrow and spend, further fueling this trend.

Fiscal stimulus is also a factor at play. The $1.9 trillion American Rescue Plan enacted in March 2021 provided additional direct cash assistance to families through stimulus payments, expanded unemployment insurance and tax credits. At the same time, workers are quitting jobs at record rates, prompting employers to offer higher wages and bonuses to entice workers. As a result of both government transfers and higher wages, Americans are saving more: The median household’s checking account balance was 50% higher in July 2021 than it was two years prior, fueling spending on goods.

Economists attribute rising overall inflation to those sectors that were relatively dormant through the pandemic but have bounced back as consumer demand accelerates. Demand for services continues to lag, suggesting that the rising prices of goods is driving the inflationary trend.

For example, prices for used cars leaped 26.4% over the past 12 months. Gas prices have reached their highest level since 2014, increasing 49.6% over last year, with a 6.1% increase in October alone. This trend is likely a result of supply chain issues within the oil and gas industry as suppliers are unable or unwilling to match surging global demand. Gas prices may continue to rise over the next few months as holiday travel drives demand further. While these price spikes are particularly pronounced, inflation is elevated for a wide swath of the economy. Since last October, prices for food, apparel, and shelter are up by 5.3%, 4.3%, and 3.5%, respectively.

As the global economy continues to shake the cobwebs of pandemic shutdowns, it is difficult to predict whether today’s inflation is transitory or persistent. However, while the long-term future of inflation remains unknown, prices appear likely to remain elevated at least through the holiday season.

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 surge in spending will eventually stabilize. Their forecast 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% for the fourth quarter of 2021 over prior year, before dropping to 2.5% in 2022 and stabilizing at 2.3% through 2031. However, even experts who contend that inflation will eventually normalize, including Federal Reserve Chair Jerome Powell, concede that inflation is proving sticky in the near-term and that policy changes may be necessary to stave off more enduring price increases.

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 (although real earnings have stagnated due to price increases), which 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. The Federal Reserve has begun tapering the monetary stimulus it provided at the start of the pandemic by reducing its $120 billion in monthly purchases of Treasury and mortgage-backed securities. Given that the American economy is still recovering from the COVID-19 recession, Chairman Powell has said that rates will remain low in the near term. This could mean that inflation still has a bit of room to run before the Federal Reserve plans to take any further significant steps to curb it. Wall Street, however, has begun pricing in a rate increase in July 2022—sooner than many analysts predicted earlier this year.  

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 economic agenda—including policies enacted under the American Rescue Plan, the Infrastructure Investment and Jobs Act, and a pending investment of approximately $2 trillion in child and elder care, climate change mitigation, affordable housing, and more—to be essential for a robust recovery. On the other hand, many congressional Republicans oppose this spending. They and some moderate Democrats are concerned that further government spending will only increase demand and maintain elevated inflation levels into next year. 

Only time will tell whether inflation proves to be transitory or persistent. Consumers will face ongoing elevated prices in the short term, however, as the economy continues to recover and rebalance. As long as inflation remains top of mind for Americans, policymakers will be pressed to respond.