In March, the Consumer Price Index for All Urban Consumers (CPI-U), rose 0.6%, the largest one-month increase since August 2012. Over the previous 12 months, the increase was 2.6%, the highest year-over-year inflation rate since August 2018.
By contrast, inflation in 2020 was 1.4%. The annual increase in CPI-U, often called headline inflation, was due in part to the fact that the index dropped in March 2020, the beginning of the shutdown in the face of the pandemic.
Thus, the current 12-month comparison is to an unusual low point in prices.
The index dropped even further in April 2020, and this “base effect” will continue to skew annual data through June. The monthly March increase, which followed a substantial 0.4% increase in February, is more indicative of the current situation. Economists expect inflation numbers to rise for some time. The question is whether they represent a temporary anomaly or the beginning of a more worrisome inflationary trend.
In considering the prospects for inflation, it’s important to understand some of the measures used. CPI-U measures the price of a fixed market basket of goods and services. As such, it is a good measure of prices consumers pay if they buy the same items over time, but it does not reflect changes in consumer behavior.
It can be unduly influenced by extreme increase in specific categories. Nearly half of the March increase was due to gasoline prices, which rose 9.1% during the month, in part because of production problems caused by severe winter storms in Texas. Core CPI, which strips out volatile food and energy prices, rose 0.3% in March and just 1.6% year over year.
In setting economic policy, the Federal Reserve prefers a different inflation measure called the Personal Consumption Expenditure (PCE) Price Index, which is even broader than CPI and adjusts for changes in consumer behavior, such as when consumers shift to purchase a different item because the preferred item is too expensive.
The Fed looks at core PCE, which rose 0.4% in March and 1.8% for the previous 12 months, slightly higher than core CPI but still lower than the Fed’s target of 2% for healthy economic growth.
Based on the core numbers, inflation is not yet running high, but there are inflationary pressures. Loose monetary policies by the central bank and trillions of dollars in government stimulus could create excess money supply as the economy reopens. Pent-up consumer demand for goods and services is likely to rise quickly, fueled by stimulus payments and healthy savings accounts built by those who worked through the pandemic with little opportunity to spend. Businesses that shut down or cut back may not be able to ramp up quickly enough to meet demand. Supply-chain disruptions and higher costs for raw materials, transportation, and labor have already led some businesses to raise prices.
Will the economy get too hot to handle? Economists expect inflation numbers to rise in the near term, but there are three major views on the potential long-term effects.
The view held by many, including Fed Reserve Chair Powell and Treasury Secretary Yellen, is that the impact will be short lived and due primarily to the base effect, with little or no long-term consequences.
Inflation has been abnormally low since the Great Recession, consistently lagging the Fed’s 2% target. In August 2020, the Federal Open Market Committee (FOMC) announced that it would allow inflation to run moderately above 2% for some time in order to create a 2% average over the longer term. Given this policy, the FOMC is unlikely to raise interest rates unless core PCE inflation runs well above 2% for an extended time. The FOMC mid-March projections sees core PCE inflation at just 2.2% at year end and fed funds rate remaining at 0.0% to 0.25% through the end of 2023.
A second view believes inflation may last longer, with potentially wider consequences, but that any effects will be temporary and reversible. A third perspective thinks that inflation could become a more extended problem and difficult to control.
Both camps project that the base effects will be amplified by demand exceeding supply and pushing prices upward. The more extreme view believes this might lead to a “cost-push” effect and inflationary feedback loop where businesses, faced with less competition and higher costs, would raise prices preemptively, and workers would demand higher wages in response.
Although it’s too early to tell whether current inflation numbers will lead to a longer-term shift, you can expect higher prices for some items as the economy reopens. Consumers don’t like higher prices, but it’s important to keep these increases in perspective.
For now, it may be helpful to remember that “headline inflation” does not always represent the larger economy. And with interest rates near zero, the Federal Reserve has plenty of room to make any necessary adjustments to monetary policy.