Inflation

I recently returned to Durham from my hometown, Hong Kong. While I was visiting Hong Kong, I took a trip to Guilin on the Mainland. Once there, I immediately noticed how inexpensive everything is in Guilin as compared to Hong Kong. Renting a moped for an hour costs the equivalent of USD 6. A bowl of delicious noodles is less than USD 1. Someone will give you a ride on a raft for an hour for a little more than USD1. Now I can see why millions of Hong Kongers are crossing the border every week to shop, eat, and tour around Shenzhen and other places in China. Prices on the Mainland are far lower than in Hong Kong. Then again, Hong Kong prices for food, dining out, and some other goods are lower than in the US. It got me thinking about inflation.

Inflation is the rate of increase in prices over a given period of time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. It can also be calculated more narrowly for certain goods, such as food, or for services, such as a massage, for example. Whatever the context, inflation represents how much more expensive a relevant set of goods and/or services has become over a certain period, most commonly a year.

To measure how much the cost of living has changed in a country, governments will often look at the cost of purchasing a basket of commonly purchased items over time. Housing expenses including rent and mortgages, account for the largest component of the consumer basket in the US. The cost of this basket at a given time expressed relative to a base year is the consumer price index (CPI), and the percentage change in the CPI over a certain period is consumer price inflation, which is the most widely used measure of inflation. For example, if the base year CPI is 100 and the current CPI is 110, inflation is 10% over the period.

The consumer price basket is kept constant over time for consistency, unless it is adjusted to reflect changing consumption patterns. If your income does not keep pace with inflation, then you will be worse off as prices rise. In other words, your purchasing power or real/inflation-adjusted income falls. Real income is a proxy for the standard of living. When real incomes are rising, so is the standard of living, and vice versa.

Obviously, not all prices change at the same rate. Commodity prices change daily, whereas salaries and wages change much less frequently. The reduction in purchasing power or real income of some consumers is the biggest reason inflation can be problematic.

Deflation, or falling prices, isn’t good either. It causes consumers to delay purchases in anticipation of lower prices, and that leads to slower economic growth. 

Most economists believe that low, stable, and predictable inflation is good for an economy. That way, it’s easier to reflect it in price-adjusted contracts and interest rates, and it will encourage consumer purchases if prices are expected to keep rising. The Fed and other central bankers have set a primary goal to maintain low and stable inflation. 

Target Inflation

For the Fed, the target for long run inflation is 2% measured by the annual change in the personal consumption expenditures index (PCE). US CPI and PCE largely track each other but there can be fairly wide divergences. The Fed switched to using the PCE in 2000. The two indices differ in how the basket components are weighted, with the housing component more dominant in CPI and healthcare spending more dominant in PCE. They are both calculated slightly differently, too. For example, the PCE formula adjusts its weights monthly, while the CPI does so yearly. When grocery shoppers switch to chicken after beef becomes more expensive, that change shows up in the PCE Index first.

There are also differences in the scope of each index. The PCE report includes purchases made by urban and rural consumers, while the CPI report only tracks spending in urban areas. The CPI includes only out-of-pocket spending made directly by consumers, while the PCE accounts for expenditures made on consumers’ behalf. As a result, health insurance expenses made on behalf of employees by their employers or by Medicare and Medicaid are included in the PCE basket but not the CPI. There are other differences.

The Fed prefers the PCE index because a) PCE data includes a broader set of good and services prices, and spending from both rural and urban consumers, b) the weights in the PCE are updated monthly rather than annually and can therefore better account for consumer substitution, and c) the government can retroactively revise PCE data to account for new data or measurement techniques. CPI data is generally only revised to account for seasonal factors.

What Causes Inflation

High inflation is often the result of loose monetary policy. For example, if the money supply grows too big relative to the size of an economy, as it did during Covid in the US, the unit value of the currency diminishes and its purchasing power falls and prices rise. 

Supply or demand pressures can also be inflationary. Supply shocks that disrupt production, such as natural disasters, or raise production costs, such as high oil prices, can reduce overall supply and lead to “cost-push” inflation. 

Expectations also play a key role in determining inflation. If people or firms anticipate higher prices, they build these expectations into wage negotiations and contractual price adjustments (such as automatic rent increases). This behavior partly determines the next period’s inflation. Once the contracts are exercised and wages or prices rise as agreed, expectations become self-fulfilling. 

How to Bring Down Inflation

Central banks like the Fed can use contractionary policies such as increasing interest rates to slow demand to help bring down inflation. Specifically, to bring down inflation in the US, the Fed raises the federal funds rate, which is the interest rate banks charge each other for short-term loans to meet their reserve requirements. Higher interest rates increase the cost of borrowing, which makes it more expensive for businesses and consumers to borrow, thus slowing the economy and bringing inflation down toward the target level of 2%. 

Some central banks have tried other methods to reduce inflation, such as altering the exchange rate to tie the value of its currency to that of another country’s currency. However, when inflation is global rather than just domestic, using the exchange rate may not help. Some governments also try to fix prices of certain goods, such as fuel, which usually results in the government accruing a large subsidy bill to compensate producers for lost income.

Some central bankers like the Fed also try to use their ability to signal or influence inflation expectations as a tool. The Fed will specify the PCE target, and indicate how it is planning to adjust rates. That signaling can help lo

wer inflation. 

With US inflation having proved to be harder than expected to bring down in 2024, it looks like the Fed will be opting for fewer and shallower rate cuts in 2025.