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Infalation and Interest Rate
Infalation and Interest Rate
Inflation is a sustained increase in the average price of all goods and services
produced in an economy. Money loses purchasing power during inflationary periods
since each unit of currency buys progressively fewer goods.
Suppose the overall price level increased by 3% during the past 12 months. If a
"typical urban household" spent $3,000.00 during the first month for all household
expenses, then they must budget $3,090.00 during the last month for exactly the same
quantity of goods and services. Prices of individual items may have increased at
different rates and some prices may have even declined, but overall they must budget
about $90 more per month now. If their income after taxes does not increase by that
amount, they must save less, substitute less expensive items, forgo some items, or
incur debt.
Inflation is often reported as a percent change in the overall price level between two
periods as measured by a price index. This chart shows December to December
changes over the past 53 years as measured by the Consumer Price Index (CPI), a
popular measure of inflation in the U.S.. Notice that the rate of inflation varied
considerably during the 1970s and into the early 1980s but has been relatively stable
recently.
The chart above shows changes in the rate of inflation, not changes in actual prices. A
downward-trending line above zero means that prices are still increasing, just at a
lower rate. This is sometimes called disinflation but it is inflation nevertheless. When
the rate falls below zero, as it did briefly in 1954, average prices actually are falling
(deflation). While lower prices may seem ideal at first from a consumer's point of
view, deflation leads to rising unemployment and falling production, a situation from
which it is extremely difficult to recover. An inflation rate of 1 - 2.5% currently seems
to be acceptable by many economists.
Since the inflation rate is a national average of all prices, it may differ considerably
from the rate experienced by any one particular household. Each household will have
different types and quantities of items in their "market basket" and therefor may
experience the effects of inflation differently.
The next chart shows how the effects of sustained inflation accumulate over the years.
It contains the CPI index values for December of each year. An index value of 180
means that prices have increased 80% measured from a base of 100. From the index
values, it is possible to calculate that a basket of goods and services that cost $3,000 at
the end of 1992 will cost $3,897.00 at the end of 2003. Our hypothetical household
cannot "wait out" inflation hoping that average prices will return to former levels.
They must insure that their income and the interest from their investments keep pace
with long-term inflation or they will become relatively poorer.
Causes Of Inflation
Long term inflation occurs when the money supply (currency and check writing
deposits) grows at a faster rate than the output of goods and services. When there is
more money available than is needed to accommodate normal growth in output,
consumers and businesses want to purchase more goods and services than can be
produced with current resources (labor, materials, and manufacturing facilities)
causing upward pressure on prices. This is often described as "too much money
chasing too few goods."
Over a shorter term, inflation can result from various shocks to the economy. Food
and energy price shocks are common examples of this in the U.S. The price of a
critical commodity such as fuel may rise suddenly and sharply relative to other prices.
Since the market does not have time to adjust other prices downward in response, a
short-term increase in overall prices occurs. The rate of inflation is sometimes
reported with food and energy omitted so the long-term, underlying (or "core")
inflation rate is revealed.
If the demand becomes greater then the current workforce and manufacturing
facilities can produce at their natural growth limits, inflation will generally occur. The
Fed can reduce economic activity by announcing a higher goal for the Fed Fund Rate
and then selling Treasury securities to shrink the money supply, raise rates, and
thereby ward off inflation. Although the Fed does not publicly state an inflation goal
as part of their policy, they have kept prices reasonably stable since about 1996 as
shown in Figure 1.
Measures Of Inflation
The three most widely used measures of inflation in the U.S. are:
The CPI and PPI are compiled by the US Bureau of Labor Statistics. The GDP
Deflator is produced by the US Department of Commerce.
The CPI, which tracks the total cost of a market basket of retail goods and services, is
the one most often reported by the media. It is further divided into versions that
represent all urban consumers (CPI-U), all urban wage earners (CPI-W), and a new
chained version (C-CPI).
"However the media usually focuses on the broadest, most comprehensive CPI. This
is "The Consumer Price Index for All Urban Consumers (CPI-U) for the U.S. City
Average for All Items, 1982-84=100." These data are reported on either a seasonally
adjusted, or not seasonally adjusted, basis. Often, the media will report some, or all, of
the following:
The CPI-U tracks the purchasing patterns of urban residents comprising about 87% of
the total U.S. population. Rural residents, armed forces personnel, and people in
institutions are excluded from it. The BLS periodically selects households within this
group and asks them to maintain detailed diaries of their expenditures. From these, the
BLS constructs a weighted market basket of goods and services containing thousands
of specific items that represent the quantity and type of goods purchased by an
average urban household. For example, all housing items were recently weighted at
about 42% and all types of food and beverages at about 15%. Then, each month, BLS
personnel canvas retail establishments across the nation to update the prices of items
in the basket and to calculate its current total cost.
All this activity results in a single index number each month that represents the
current price of the basket relative to a base index of 100. The current base index was
calculated by setting the average price level of the basket during the reference period
of 1982-1984 equal to 100. An index number of 180 means prices have increased 80%
from the base index. An index of 40 means prices have declined by 60% from the
base index.
The percent change in the CPI between any two periods can be calculated by:
Figure 2 shows that the price index for December 1992 was 142.30 and the index for
December 2003 was 184.90. The percent change in the CPI is ((184.90 -
142.30)/142.30) * 100 = 29.9%. Although prices fluctuated considerably between
those dates, the end result was about a 30% change. A market basket that cost $3000
at the end of 1992 cost $3,897.00 (1.299 * 3000) at the end of 2003.
Some believe that the CPI-U generally tends to overstate inflation 3 . The contents and
weights assigned to the market basket remain constant over many reporting periods. If
the price of a particular item in the basket increases significantly, households may
very well substitute less expensive alternatives. However, the CPI-U will continue to
price the contents of the original basket as though consumers had no other choices.
The BLS have adjusted their methods to partly compensate for substitution, but it has
not been completely eliminated. Even a small difference can have a profound effect
on the economy since many large contracts are adjusted for inflation by this index.
The Fed has begun to use the newer Chained CPI-U (C-CPI-U) in some reports since
they feel it states inflation more accurately.
Although it may not be a perfect indicator, the yield of a 10 year, fixed-rate
U.S.Treasury note when compared with the rate of a Treasury Inflation Protected
Security (TIPS) of the same maturity at least shows that some amount of inflation
premium certainly does exist. For example, the Fed Funds rate was recently at 1% and
the year-to-year percent change in the CPI (current inflation rate) was 2.3%. At the
same time, the anual yield of the fixed-rate note was 4.75% while the TIPS note was
at 2%. This would indicate that the market currently expects an average annual
inflation rate of around 2.75% (4.75% - 2%) over the ten year period and have added
that inflation premium to the fixed-rate, non inflation protected note.