Inflation
Inflation is a sustained increase in the average price level of goods and services. While prices for individual products – such as gasoline or meat – may rise, this does not necessarily mean that inflation is occurring, as inflation is a general increase in prices.
The speed at which prices increase is called the inflation rate, which rose to 8.6% in May from 8.3% in April, according to the latest reading of one widely used measure, the Consumer Price Index (see definition below). In other words, prices in May were 8.6% higher than prices in May 2021. For comparison, the inflation rate had hovered around or below 3% in most years since the early 1990s, with the last time that this high level was reached being in 1981.
As prices rise at a faster-than-usual rate, the big question is how long this increase will last and what can and should be done about it.
Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE)
The Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) are both government indicators of consumer prices. Changes in either are often measured on an annual basis, with inflation occurring when they rise and deflation when they fall.
For each index, there is a “headline” inflation rate as well as a “core” inflation rate (see definition below) that excludes prices from volatile food and energy sectors. The details of how price changes are measured and what is measured differ, which explains why the Consumer Price Index tends to reflect more inflation than the Personal Consumption Expenditures Index.
The Consumer Price Index (CPI), released by the Bureau of Labor Statistics, measures how much urban consumers pay for a fixed basket of goods and services based on household surveys. The basket is fixed, measuring price changes for the same basket each month, and considers only cash outlays, so items that are not directly paid for – such as medical care or health services – are not included.
In contrast, the PCE index published by the Bureau of Economic Analysis reflects the prices of goods and services sold by businesses. This includes items that are not directly paid for by consumers, such as medical care paid through employer-provided insurance, and takes into account changes in consumer choices, making the basket more variable. For example, if the price of bread rises significantly and people stop buying it, the weight of bread decreases in the calculation.
While the government uses the Consumer Price Index to calculate changes in benefits such as Social Security, the Federal Reserve pays more attention to the PCE index when determining monetary policy. The Federal Reserve prefers the PCE for three reasons: its flexibility in accounting for substitutions, its more comprehensive coverage of goods and services, and the ability to revise historical PCE data comprehensively compared to CPI, which is revised only for seasonal adjustments. The PCE index fell in April (May data has not yet been released) to 6.3% from 6.6%.
Core Inflation Rate
The core inflation rate is a measure of inflation that excludes the costs of food and energy. Although these items are considered an important part of household budgets, they rise and fall significantly and often. As a result, experts carefully study the “core” inflation rates of more stable items to get a better sense of long-term trends, which is particularly important for policymakers. In the latest government Consumer Price Index report, core inflation slowed to 6% from 6.2% in April.
Interest Rates
The Federal Reserve aims for an average PCE inflation rate of around 2% in the long term. One tool the Federal Reserve has to control inflation is raising the benchmark interest rate, known as the federal funds rate, which affects a wide range of other interest rates, such as those on credit cards, auto loans, and mortgages. So far this year, Federal Reserve officials have raised the target range for the rate by 0.25 percentage points, bringing the federal funds rate to 0.75% – 1%. Several more rate increases are planned for this year and next. When interest rates rise, borrowing money to buy things becomes more expensive, so demand for goods and services should decrease. This, in turn, should reduce inflation.
Decline
Sof Landing
When you raise borrowing costs to combat inflation, you also slow down the economy. But like a plane, you want a soft landing – not a crash – for the economy. That’s why the term is often used to describe the Federal Reserve’s goal when it is in a rate-hiking mode.
In other words, the Federal Reserve has begun raising the benchmark interest rate, the federal funds rate, to cool the economy and curb sharp increases in consumer prices. But Fed officials must not overdo it, so the economy slows down to a point where it slips into a recession. That would be a very hard landing. It’s a delicate balancing act, and Federal Reserve Chairman Jerome Powell has acknowledged that it won’t be easy. Fed officials believe the economy is strong enough to engineer a soft landing, but some economists think the odds are against them.
COLA
COLA stands for “Cost-of-Living Adjustment,” which is when social security payments and supplemental security income are increased so that beneficiaries’ purchasing power (see definition below) isn’t eroded by inflation. These payments increased by 5.9% in January, the highest COLA in four decades. For the average retired beneficiary, that means an average increase of $92 per month.
Purchasing Power
Purchasing power means how much you can buy, which is determined based on how much money you have and how much things cost. One way to measure purchasing power is through “real earnings,” which compare the pace of wage growth to the pace of price increases. These days, inflation is cutting into the benefits of wage increases.
Supply Chain
The supply chain is the entire process of producing and delivering goods, from raw materials to factories to your doorstep or shopping cart.
When the supply chain gets disrupted anywhere along the way – for example, at a port where container ships can’t be unloaded fast enough – a “bottleneck” is created, and anything stuck on the wrong side of the bottleneck can become scarcer and more expensive on the other side, contributing to rising inflation. Economists are currently seeing bottlenecks arising from the pandemic everywhere, from homebuilding and heating oil to the automotive industry.
Stagflation
The term stagflation is used to describe an economy that is experiencing high inflation, high unemployment, and slow economic growth all at the same time. It is unusual because inflation is supposed to occur when unemployment is low and the economy is growing. Some analysts have recently said that the U.S. economy may soon enter a period of stagflation.
Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we fact-check and maintain the accuracy, reliability, and trustworthiness of our content.
Bureau of Labor Statistics. “Consumer Price Index Summary.”
Federal Reserve Bank of St. Louis. “PCE and CPI Inflation: What’s the Difference?”
St. Louis Federal Reserve. “CPI vs PCE Inflation: Choosing a Benchmark Measure.”
Bureau of Economic Analysis. “Personal consumption expenditures price index, excluding food and energy.”
Federal Reserve Board. “Statement on Longer-Run Goals and Monetary Policy Strategy.”
Federal Reserve. “Summary of Economic Projections.”
Morgan Stanley. “Can the Fed Engineer a Soft Landing?”
Federal Reserve. “Acting Fed Chair Powell’s Remarks on Restoring Price Stability.”
Social Security Administration. “Latest Cost-of-Living Adjustment.”
International Monetary Fund. “Inflation: Prices Rising – Returning to Basics: Finance and Development.”
Institute for Supply Management. “What is the Supply Chain?”
Federal Reserve. “The Great Inflation | A History of the Federal Reserve.”
Source: https://www.thebalancemoney.com/inflation-dictionary-your-guide-to-the-jargon-5206432
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