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Markets and Economy

Why Inflation Is So Hard to Predict

Over the last two decades, the official measure of inflation has remained unusually tame despite the rising prices of many goods and services. Why have inflation trends been so difficult to predict, and what does that mean for the future of monetary policy?

Over the last two decades, the official measure of inflation has remained unusually tame despite the rising prices of many goods and services. Why have inflation trends been so difficult to predict, and what does that mean for the future of monetary policy?


Inflation’s tame behavior over the past two decades has been puzzling. Even as the level of aggregate consumer demand has pushed against the limits of what companies can produce, inflation hasn’t accelerated beyond the Federal Reserve’s 2 percent target.

As the business cycle nears its peak, the Fed has paused interest rate normalization until price pressures begin to emerge. But knowing when that will happen has proven challenging—a closer look at inflation trends reveals a complicated picture. Since no single indicator can reliably predict inflation’s trajectory, how can the Fed set monetary policy to promote price stability?


Index Versus Experience

For many consumers, the official inflation statistics don’t match their firsthand experience of seeing retail prices steadily rise. But measuring inflation is more complicated than tracking price movements. Instead of looking solely at changing prices, the Fed relies on the core personal consumption expenditures index (PCE), which attempts to quantify how quickly the overall cost of living is rising. Several factors contribute to the mismatch between the perception of prices and the reality of inflation:

●  Substitution: The PCE assumes that consumers can substitute products for others with similar functions. For example, if the price of cotton rises, policymakers assume that many consumers will substitute apparel woven from synthetic fabrics. So even a substantial increase in the price of cotton goods may not raise the overall cost of living index.

●  Quality adjustments: The index also adjusts for the improving quality of goods. For example, automobile prices rise every year, but inflation is only partially to blame—cars are also getting better. Features that were once luxuries have become standard, and every new model year makes strides in safety, reliability and efficiency. So, although the average price of a new car has risen $7,332 since 2009, the BLS attributes a full third of the increase to quality advancements.

●  Infrequent expenditures: The index also includes big-ticket expenditures that households encounter only sporadically. For example, the typical consumer may be well aware that the price of laundry detergent rises every year, but they probably don’t know that the price of a typical washing machine has actually fallen 12 percent since 1999. Consumers feel the higher prices of everyday items acutely, but the cost of living must also account for less common expenditures.   

●  Expenses not measured: Food and fuel outlays make up a large portion of household budgets, but they’re excluded from core inflation indices. Higher prices at the pump can certainly make consumers feel like their paychecks aren’t stretching as far, but the price of fuel is often driven by supply-side developments that monetary policy can’t control. For example, when gas prices cratered in 2015, it wasn’t due to weak aggregate demand; rather, the shale drilling boom had rapidly increased the supply of oil, creating a glut that drove prices down. There’s no reasonable action the Fed could take to contain supply-driven price volatility.


No Early Warning From Labor 

In previous business cycles, a tightening labor market has provided an early warning of inflationary pressure. When the supply of available workers could no longer meet industry’s demand for labor, wages would begin to rise unsustainably, and climbing production costs were passed on to consumers.

But over the past 20 years, the labor market has grown more competitive, less regulated and more transparent. In a globalized economy, wage growth is largely driven by productivity gains, not labor shortages. This may be why the headline unemployment rate has been able to fall to new lows without sparking an inflationary spiral.


The Logic of Patience

With no way of reliably forecasting inflation, the Fed’s patience in the face of unsustainable job growth may seem strange. Aggregate demand is clearly closing in on the economy’s capacity to supply goods and services, a threshold at which inflation will likely begin to build in earnest. To some, it seems the Fed should act now, ahead of price pressure.

But the Fed’s 2 percent inflation target is symmetrical. Policymakers expect inflation to fall short of the target during downturns, and they’ll allow prices to rise higher than the target during boom years. Inflation has been running persistently below-target throughout the expansion. The Fed may prove willing to allow job creation to continue exceeding expectations until inflation becomes a concern.

Ultimately, the Fed’s patience is likely bolstered by the fact that interest rates are already on the cusp of neutral territory. Only two additional hikes would be necessary to lift short-term rates to their expected long-term equilibrium of 3 percent. When inflation finally exceeds the Fed’s target, controlling price growth should be as simple as two gradual rate hikes. Right now, patience is a luxury the Fed can afford.

View our economic commentary disclaimer.


Jim Glassman