Tag: inflation

On June 13, the Federal Reserve released updated inflation figures showing that the Consumer Price Index grew at a 4% annual rate in May. The difference in consumer prices from April to May, however, was just 0.1%. These two numbers paint very different pictures of the current state of inflation and the American economy.

The confusion comes from the way in which we calculate inflation, according to John Horn, a professor of practice in economics at the Olin Business School at Washington University in St. Louis. Horn earlier explained how the “math” of inflation works.  

“As a refresher, inflation is an annual measure—the increase in prices over 12 months,” Horn said. “The Bureau of Labor Statistics creates a representative basket that an average person would buy, then calculates the price for that basket. The formula for inflation is:

“That’s just the definition of a percentage change: the change over time divided by the initial value. Using this formula means inflation can increase really fast but has a hard time coming back down. That has nothing to do with economics; it has everything to do with math.”

Take a very simple example. Say the monthly price for the basket of goods is $100 every month and has been for a couple of years. That means inflation is 0%, since (100-100)/100 equals 0%. If the price suddenly increased to $110 in January, then inflation would be 10% because (110-100)/100 equals 10%.

But here’s how annual inflation numbers can distort the economic reality: If prices stayed flat in February, then the price of the basket would still be $110, and inflation would be: $110 (current February’s price)-100 (last February’s price)/100 (last February’s price). That’s 10% again. And in March, if prices stayed flat at $110? Then current March equals $110, last March equals $100, so inflation is (110-100)/100, which equals … 10%.

In this simple scenario, there was a one-time fast increase in prices and then prices stayed stagnant for a full year, but the lag in inflation calculation would lead to 10% inflation for a full year.

“This is troublesome because the news reports and headlines would scream, ‘Inflation stays stubbornly high at 10%,’” Horn said. “That’s true, but in terms of buying power, there was only a one-time increase in prices. For the rest of the year, prices stayed flat—admittedly, at an elevated rate. And that’s assuming prices remain stagnant after January. Even in a healthy economy, we expect prices to rise modestly — typically around 2% annually.”

“When prices continue to rise modestly after a one-time spike in prices — as they did in 2022 — it can make the situation seem much worse than it really is,” Horn added.    

Perception versus reality

The latest Bureau of Labor Statistics figure shows inflation for May 2023 was 4%—good, but still above the Fed’s target level of 2%. What should inflation have been if prices had started rising at 2% starting in August 2022?

“Under this scenario, the annual inflation rate in May would have been 3%,” Horn said. “Is that below the 4% we’re actually at? Sure, but not that far off to think we’re wildly stuck in an inflationary economy. In fact, since December 2022, we’ve been off this 2% trendline by about 0.5 to 1% each month — pretty steadily, in fact. We are running only slightly ahead of where we should be.”

“Overall, inflation is not running away—as you can see in the chart—it’s gliding back to the path we’d like to see of around 2%,” Horn said.

When thinking about the economy, and inflation in particular, Horn said it’s important to not fall into “base rate fallacy” thinking by focusing too much on specific details — like the prices of commercial real estate, used cars or eggs — and ignore the larger-picture trends. For example, there are some worrying trends in rental rates, since those prices are rather sticky for longer periods of time, baking in those changes into inflation for longer. But those changes are often offset by changes in other products’ prices in the overall basket.

While rental prices are currently keeping inflation up, unemployment — which is often mentioned as a driver of higher inflation — has stabilized at the rates we saw right before the COVID-19 pandemic, when inflation was right around the Fed’s target of 2%, Horn said.

Looking back to last summer, Horn pointed out that many feared the Fed would either overcorrect by raising interest rates too high, which would throw the economy into a recession, or it was going to undercorrect and raise interest rates too little and create endemic inflation that would never come down.

“No one had great confidence that the Fed could achieve the soft landing, whereby the economy didn’t enter a recession while inflation slowly came back down to the 2% target,” he said. “We clearly didn’t have a recession, and while we’re still about a percentage point too far above the tarmac, the plane appears to be on an approach glide path.

“At least, if we take a longer view and remember the math behind inflation,” Horn said.

The monthly news headlines are alarming: “US inflation hit 40-year high in June,” “US inflation eased slightly to 8.5% in July.” To the casual observer, it may seem like prices are going to continue to climb for the foreseeable future.

To be certain, inflation is a serious problem and has been for more than a year. “Prices are higher than they were pre-pandemic and that has put pressure on consumers’ pocketbooks and ability to afford the things they need to live a comfortable and productive life, especially since wage increases have not kept up at the same pace as inflation increases,” said John Horn, professor of practice in economics at Olin Business School.

However, focusing on the annual rate of change, rather than month-to-month inflation changes, distorts the economic reality, making an already bad situation look worse, Horn explained. And that’s a problem because we may convince ourselves that the price level will continue to increase.

“High inflation could become a self-fulfilling prophecy that would require a deep recession to shake off, which would definitely not be a good outcome for those struggling to make ends meet,” Horn said.

To better understand the math of inflation, Horn offered the following explanation.

How is inflation calculated?

“The government statisticians select a bundle of goods that represent a ‘typical’ basket of goods consumers buy in a given month. This bundle is periodically updated but is kept constant from month to month. The analysts then determine the price for each of the items in the bundle and sum across all the items to determine a total expenditure for buying the entire basket. This is called the current price index. They then compare this current price index to the total expenditure for buying the bundle at a fixed point in time in the past (the base year index value) to determine how much prices have increased in the intervening period,” Horn said.

“The percentage change in inflation is calculated by taking the price index today, subtracting the price index in the previous time period of interest and then dividing by the previous price index. That’s the basic formula for a percentage change: (current value – prior value)/prior value.

“So far, pretty straightforward. Let’s look at the current CPI (consumer price index) numbers. In July 2022, the index was 296.276. In June 2022, the index was 296.311, and in July 2021, the index was 273.003. Let’s calculate the annual inflation rate. That’s today’s index (296.276) minus last July’s index (273.003) divided by last year’s index (273.003). The result is 8.5%, which is the number the Bureau of Labor Statistics released a couple of weeks ago.

“The monthly inflation rate — or change in prices from June 2022 to July 2022 — was 0.0 percent. We get this by taking July’s index (296.276) minus June 2022’s index (296.311) and dividing by June’s index (296.311). When rounded up to one decimal place, the answer is 0.0 percent. It’s actually very slightly negative, but this goes away with the rounding,” Horn said.

So, we’re comparing apples and oranges?

“It is pretty bad that inflation was 8.5% over the last year, and it sounds like prices keep increasing by almost 10%. But what if the prices stayed constant? What if the economy ‘fixed’ itself and prices were flat — staying at 296.276 — for the next 12 months? Prices would be higher than they were 12 months ago, but they would stop increasing. If that happened, most consumers would still wish for the prices from three years ago, but at least they wouldn’t be increasing,” Horn said.

“Here’s where the math gets interesting. If prices stay flat for the next 12 months, then here is the annual inflation rate for every month:


“Inflation won’t go back to a ‘normal’ 2% until May of next year. Remember, that’s if prices stay flat for every month, so the month-on-month inflation rate is 0%.

“The reason this happens is that we’re comparing today’s index to a price from a year ago. For the past year, prices have been increasing really fast. The CPI index hit 250 in April 2018. It got to 260 in September 2020, two and a half years later. It reached 270 in June 2021, or nine months later. It ballooned to 280 in six months (January 2022) and four months later was at 290. That means prices have increased 5.4% since January.

“If prices stay flat, inflation next January will still reflect that 5.4% increase over the entire year. Again, that feels like really high inflation, when in fact prices will have been flat for six months — hypothetically.

“Annual inflation numbers can adjust quickly on the way up, but they will take time to come back down because of the lag in calculating inflation. It takes a long time for the 12-month lag in prices to catch up to today’s higher prices and get inflation back down to the 2% range we expect.

“The Personal Consumption Expenditures (PCE), which the Federal Reserve uses to measure inflation, is calculated a bit differently than the CPI, but it also shows the same ‘math’ persistence. If prices stay the same in the PCE metric, then we’ll be back at 2% inflation next March,” Horn said.

What if prices fell, would that correct inflation faster?

“The easy answer might seem to have prices fall in the next three months to get the CPI index back to the 275 level we saw at the end of last year. That would move the annual CPI back toward the 2% range faster, but that would also risk kicking off deflation, which can be as bad or worse than high inflation.

“If prices fell by 7 or 8%, then many consumers would think, ‘That’s great, but prices are still well above what they were before the pandemic, and they’ve been dropping quickly, so I’m going to hold off buying until prices drop a bit more.’ That reduction in consumption will lower demand, which will in fact lower prices further. But that will encourage even more consumers to hold off on purchasing, which will decrease prices further. It becomes a self-reinforcing cycle that has the effect of pushing the economy into a recession — exactly what the Fed is trying to avoid,” Horn said.

If prices can’t fall quickly, and we’re stuck with the ‘math,’ what should we do?

“One thing would be to focus more on the month-to-month trends, at least in the next few months,” Horn said. “If CPI holds flat or slightly negative through the fall, that’s a good indication that prices are stabilizing. They’ll still be well above their levels from two to three years ago, but we’ll avoid the deflationary spiral.

“Month-to-month inflation rates are typically noisy, so they are not a good metric for longer-term planning by the Fed during periods of stable inflation. But in times of crisis, they can provide a better measure of the current movement in the economy.

“The other benefit of focusing on the month-to-month is the messaging it provides to consumers and producers in the economy. Continuing to focus on the annual numbers will result in another six months of ‘historically high’ inflation. The messaging that the annual rate is decreasing will get lost in the headline attention-grabbing ‘Inflation still at near record levels.’ This increases the risk that consumers and producers develop an entrenched mindset that high inflation is here to stay.”

On June 16, the Federal Reserve announced it may raise interest rates twice in 2023 in response to higher-than-expected increases in inflation. In his announcement, Fed Chairman Jerome Powell said the higher inflation recorded this year should be temporary, but the risks that it would be “higher and more persistent than we expect” could not be ignored.

John Horn, professor of practice in economics at Olin, agrees with Powell’s overall inflation forecast of 3.4% for 2021. Inflation in some high-demand categories — such as travel, construction material and automobiles — may be even higher, he said.

However, some prices, such as lumber, are already coming back down, providing hope that current inflation is a short-term corrective measure and not a sign of long-term systemic problems.

“The uncertainty for me is how this gets played politically and what messaging gets through,” Horn said.

Inflation, Horn explained, can be a self-fulfilling prophecy. Worry about rising inflation can lead employees to demand higher wages. In order to pay those higher wages, employers raise prices for their products and services, creating actual inflation. The wage-price spiral is a vicious cycle. Likewise, inflation expectations will cause banks to increase interest rates, making it more expensive for businesses and individuals to borrow money.

“It’s important for the Fed to make sure that this is seen as a temporary blip and not systemic. Because if it’s seen as a systemic problem, and inflation expectations take charge, it’s really hard to make it stop,” Horn said. “Once that happens, the only way to stop inflation is to raise the interest rates really high and cause a recession. Maybe not in 2022, but it will be on the Fed’s radar. They will want to stop [rising inflation] sooner than later.”

“However, if prices come down and people see this as a temporary blip related to COVID-19 and the supply chain problems — if that story takes hold — then I’m not worried about inflation,” he added.

What’s driving inflation?

In the simplest terms, inflation occurs when consumer demand increases or supply contracts causing prices to rise. The current economic situation is a little more complicated, in part because both effects are occurring.

“There’s not a clear understanding of what is currently driving inflation, but most people are pointing to a couple of things,” Horn said. “First, as the economy is recovering from COVID and the shutdown, there has been an increase in demand for things people weren’t buying over the last year due to uncertainty about job future or lack of opportunity — like travel and dining out. As demand increases, so do prices. That’s one driver.”

Adding to the problem, many of the fastest growing sectors — including travel and hospitality, entertainment and restaurants — are struggling to find people to fill open jobs. These jobs typically don’t pay the best wages, and some would-be-workers are looking for better opportunities in other industries. Lack of child care and fears over COVID-19 exposure also are keeping former employees from returning, Horn said.

Another contributing factor: When the pandemic hit, companies scaled back production or, in some cases, shut down factories altogether. Now that demand is increasing, it will take time for the supply chain and production to catch up, Horn said. A highly publicized example of this is the global shortage of semiconductor chips.

“They are used in more things than might expect — not just electronic devices, but also automobiles and appliances. Even if production capacity is available, the raw material inputs are not always available. When we think of the supply shock, the supply is constrained because all up and down the supply chain, companies slowed down or shut down at the beginning of pandemic. And the startup is not instantaneous,” Horn said. 

Ongoing effects of trade wars started under the Trump administration also have driven inflation.

“International trade normally lowers price because you have more opportunities for competition and lower prices,” Horn said. “The trade conflicts, coupled with COVID, have reduced that as an option for price competition.”

While a boost in international trade would have a positive effect on inflation, many of the countries that have historically provided lower-cost labor will continue to struggle with COVID-19, Horn added.

A measured response

The trillion-dollar question of the day is whether the current inflation is just a corrective shock coming out of the COVID-19 pandemic or rather a longer-term systemic shift. The answer will be primarily determined by monetary policy, Horn said.

Since the Great Recession of 2008-09, central banks around the globe have been pumping money into their national economies in an effort to stimulate the economy. Before the Great Recession, the Fed had just $800 billion in the economy. Today, that figure has grown six-fold to $6 trillion.

“When that extra money is out in the economy and there’s not more products to buy, prices will go up because consumers will be willing to pay more to get the products they want,” Horn said.

“That’s the longer-term systemic problem with having an increase of money in the system. And most central banks around the world have been doing this for more than a decade.”

Decreasing the money supply without triggering a recession is a challenge, though. Before the pandemic, the Fed had successfully decreased the money supply to the $3-tillion range. But, over the past 15 months, the money supply has doubled and surpassed its post-Great Recession peak, Horn said.  

“This really is a balancing act: How fast can they pull back on money supply to prevent inflation from taking off without putting the brakes on the economy just as we’re recovering from COVID?” Horn said.

“If the Fed takes the money out too slow, it causes systemic inflation, as opposed to temporary corrective inflation, which may be what’s happening right now. On the other hand, if they start to incrementally increase interest rates ahead of that happening, they’ll also cause a recession. It’s not like the global economy is so stable and strong that the Fed has a lot of wiggle room to play with.”

While it has been more than 40 years since the U.S. experienced serious inflation, the country has already experienced two significant recessions in a little more than a decade. A third recession could be disastrous, especially for younger generations. Getting this response right is of the upmost importance, Horn warned.

“My grandparents’ generation lived all their lives as if they were still in the Depression,” he said. “There already is some evidence that younger generations — Gen Z and millennials — are starting to behave this way. If that cohort goes through three major recessions in less than two decades, it will affect consumption — probably for the rest of their lives.

“That’s not good for the long-term economic growth of the U.S.”   

As team revenues increase, professional baseball salaries continue to surge with the latest out-of-the-ballpark figure of $217 million offered to David Price to play for the Boston Red Sox. Patrick Rishe, Olin’s director of the Business of Sports program, told the Marketplace public radio program that it’s a matter of supply and demand:

“Every market, there’s supply and demand considerations,” said Patrick Rishe, director of sports business at Washington University in St. Louis and founder of the research firm Sportsimpacts. “But a top-flight, left-handed starter is in short supply. Most of us are not as in short supply in terms of how unique we are to our employers.”

The average baseball player salary is reportedly 66 times the average American household income. And the next big contract for the next David Price will be more inflated than the last.

Link to Marketplace story