What is Inflation and When Will it End?

Inflation is a hot topic in the news. Even if you’re not following it in the media, you are most likely feeling. The two most common places where people are feeling the pinch of higher prices are in food and fuel costs. They are also the two things people cannot live without. Price inflation is not limited to food and energy, though. It affects all sorts of products and services such as building materials, airline tickets, hotel and car rentals, and new and used cars.

WHAT IS PRICE INFLATION?

Price inflation is an increase in the costs of goods and services and is a normal part of established economic cycles. When inflation is high, everything costs more, and you feel it in the checkout line. The reason inflation is in the news right now is that prices have increased a lot and more rapidly than they have recently.

HOW IS INFLATION MEASURED?

Economists have a variety of tools to help them measure and report on changes in prices. They rely heavily on the following indexes, which are reported on monthly.

• The Consumer Price Index (CPI) is the most cited measure of price inflation and measures the monthly change in prices paid by consumers. The CPI uses a weighted average of prices for products and services typically purchased by consumers.
• The Producer Price Index (PPI) measures the increase in wholesale prices—the amount businesses are charging each other for goods.
• The Personal Consumption Expenditures Price Index (PCEPI) measures price changes in consumer goods and services. This index includes how much is spent on durable and non-durable goods as well as services. It is based on prices paid by households, corporations, and governments. Though this is a lesser-known index, it is the price change metric most closely followed by the Federal Open Market Committee (FOMC).

Invest in a Greener Future and Save

Earn competitive rates while funding clean energy loans with a VGreen Money Market account.

Learn more

HOW DID INFLATION EVOLVE AND WHEN WILL IT END?

Prices were increasing steadily coming out of the pandemic recession. Starting in about January of 2021, the rate of inflation escalated and gained momentum and has continued a steep, upward trajectory since that time. Only the most recent report on price increases for July indicated a possible slowdown in the rate of price increases. However, this is only one month worth of data and one month does not make a trend.

The Federal Reserve Board, which is responsible for setting monetary policy in the United States, initially characterized the price inflation we are experiencing as “transitory,” implying that the price inflation was part of a phase of the economic cycle and would quickly resolve itself. The term “transitory” was regularly used in the business media to indicate that the price inflation would not be permanent. Federal Reserve Chairman Jerome Powell used the term “transitory” on multiple occasions to describe the ongoing price inflation. Since the end of 2021, Chairman Powell has acknowledged that the price inflation this economy is experiencing is not “transitory.” This price inflation is not going away on its own.

The Federal Reserve now recognizes that they were caught off guard by the rate and speed of price increases. They are clearly behind the curve on bringing down price inflation. Members of the Federal Open Market Committee (FOMC), a subcommittee of the Federal Reserve System responsible for ensuring price stability and sustainable economic growth, has openly acknowledged that they have their work cut out for them in bringing down price inflation.

WHAT IS THE FEDERAL RESERVE BANK DOING ABOUT IT?

The Federal Reserve Bank (FRB) has stated that bringing down price inflation is its number one priority right now. Unfortunately, they have limited tools for accomplishing this priority. Their primary tool for reducing price inflation is monetary policy. Monetary policy includes adjusting short-term interest rates.

The FRB has embarked on a path to raise short-term interest rates to slow down the economy. Raising interest rates makes it more expensive to borrow money to make purchases, and it improves the return people can make on their deposit dollars. This makes it less likely that people will buy things and more likely that they will save, which results in a slower economy.

The objective is to slow economic growth to the point of decreasing price inflation. In other words, as people stop spending money, there is less demand in the marketplace. As demand is reduced, prices go down, bringing inflation down for the ride.

One of the problems with raising short-term interest rates to bring down price inflation is that it is a dull tool. It is difficult for the FRB to gauge how high short-term interest rates must be increased to have the desired impact. It can take months, and sometimes years, for increases in short-term interest rates to begin to slow the economy and affect price inflation. This can involve multiple FOMC meetings over a year or more. Because the economy is dynamic, raising short-term interest rates does not occur in a vacuum. There are many other moving parts to the economy that can offset the effect of raising the short-term interest rate that the FRB is trying to achieve.

To achieve this objective, the FRB will have to walk a very fine line. If they don’t raise short-term interest rates far enough and fast enough, price inflation will continue to increase and become more painful for the consumer. If the Fed overshoots and raises short-term interest rates too much, too fast, they will choke off economic activity, which could potentially put the economy in recession.

The Fed will attempt to achieve a “soft landing.” A soft landing means that the economy won’t go into recession—price inflation will go down and unemployment won’t increase significantly. This is easier to explain than it is to carry out because, to accomplish it, they have to balance conflicting goals. If the economy goes into recession, unemployment will increase (something we don’t want).  If we go into recession and unemployment rises, price increases will slow down (something we do want).

IS THERE HOPE?

History has shown that our economy moves in cycles, so what goes down, will at some point go back up. These are unprecedented times. Nobody has a crystal ball, but it will likely recover and boom again even if the economy takes a deep dive in the near term. The only question we can’t answer is when that will happen.

Worried about Your Credit?

This eBook can help you improve your score.

Download the eBook

About Terence Field

Terry Field is the senior vice president of finance at VSECU. In his role, he is involved with the other members of the Senior Management Team and members of the Asset Liability Management Committee in setting both loan and deposit rates. During his tenure at VSECU, Terry has seen the highs and lows of the interest rate cycles. When Terry isn’t trying to guess the future direction of interest rates, he is riding his bike in the summer and skiing in the winter.

See all posts by this author