Price stability is a significant objective of monetary policy. When inflation is high, variable or both, it interferes with the efficient operation of the economy and can reduce economic growth. In addition, once inflationary expectations have been set, bringing inflation back down can be painful.
Americans have been enjoying a long period of price stability. At its modern peak in 1980, consumer price inflation stood at 13.5 percent; since 1983, in contrast, there has been only one year, 1990, when it reached even 5 percent on an annual basis. Most years during that period, it has ranged from 2 to 4 percent. Thus, for nearly three decades, general price inflation has not been a salient issue in the day-to-day economic decisions of the American public.
For some members of the public, the prospect of greater inflation has become a concern on account of the Fed's policies of monetary accommodation formally called Large Scale Asset Purchases and colloquially known as "QE" (for "quantitative easing"), "QE2," and "QE3." The concern is that when the Fed purchases assets, such as Treasury securities, and essentially creates new money to do so, as it has done in carrying out these programs, the creation of new money will prove to be inflationary. Recent inflation figures, as well as financial indicators such as bond yields, do not yet suggest that high inflation is on its way back. Instead, much of the new money is being held as excess reserves with the Fed.
To be sure, some individual goods and services have seen significant price increases at various times even as overall inflation has remained low. Undergraduate tuition at four-year institutions, for example, has risen since 1983 at a rate more than twice as fast as the overall rate of inflation. From mid-2010 to mid-2011, average retail gasoline prices went up 30 percent. Because the Bureau of Labor Statistics determines the consumer price index (CPI) by tracking the prices of a basket of representative goods and services, the CPI can stay level while some goods and services are rising in price and others are falling. Different goods and services have different weights in the calculation of the CPI, so a 10 percent increase in the price of any good would always translate into less than a 10 percent increase in the overall CPI; just how much of an increase depends on the amount of weight that the good has been assigned by the Bureau of Labor Statistics. Gasoline, for example, is weighted as 5.274 percent of purchases (meaning a typical household spends a little more than 5 percent of their total purchases of goods and services on gasoline). So a 10 percent increase in the price of gasoline would add only 0.5 percentage points (with rounding) to the CPI.
The Importance of Price Stability
Maintaining stable prices is one of the three objectives that Congress defined for the Fed in the Federal Reserve Act, along with maximum employment and moderate long-term interest rates. Inflation is a concern of policymakers for good reason: It eats into the purchasing power of households' money and effectively taxes their consumption of goods and services, even if they are not always aware of it.
The worst-case scenario — which, fortunately, the United States has never remotely approached — is hyperinflation. In Argentina in 1989, inflation hit 3,080 percent; in October 1923, inflation in Germany reached 29,720 percent. In such cases, the effect on the economy and on everyday life is severe as money starts to break down as a medium of exchange. Workers may have to be paid multiple times a day to keep up with rising nominal prices of food and other essentials, while banks may be unable to function because they cannot set interest rates high enough to attract deposits. Also, it is well-documented that growth falls sharply during periods of high inflation — not only during an Argentina-like hyperinflation crisis, but also during periods when inflation reaches lower, but still significant, levels in the range of 40 percent or more (López-Villavicencio and Mignon 2011; Bruno and Easterly 1998).
But how do less drastic levels of inflation affect economic activity? It is helpful to break this question into two parts. First, how does inflation affect economic activity when the its level is steady and known? Second, how does inflation affect the economy when its level is variable and unpredictable?
Steady inflation creates inefficiency as it forces market participants to find ways to protect themselves from money's declining value. Even at modest levels, inflation may eat into purchasing power relatively quickly. For example, at an inflation rate of 6 percent, money loses half its value every 12 years. Indeed, even with the modest inflation rates of the past three decades, the dollar cumulatively has lost considerable value over time. According to CPI data, a dollar in 1983 is now worth a little over 43 cents in constant dollars — that is, it would now purchase less than half of what it would have in 1983.
Most market participants are able to protect themselves from steady inflation — for example, with inflation-indexed contracts or frequent price increases — but these devices require resources. Moreover, to the extent that they track inflation imperfectly, such devices create inefficient distortions in relative prices. It has been estimated that a permanent reduction in the inflation rate of one percentage point leads, on average, to an increase in per-capita income of 0.5 percent to 2 percent (Andrés and Hernando 1997).
In addition, there are distributional effects to steady inflation. Some participants — especially those relying on a fixed income that is not inflation-indexed — have no means of avoiding its fiscal bite. Finally, if tax brackets are not indexed for inflation, taxpayers will be pushed into higher brackets, thereby spurring the use of economically inefficient tax-avoidance strategies.
High inflation rarely follows a steady course; rather, inflation and inflation variability tend to go together (Dotsey and Sarte 2000). When inflation is variable, the problems of inflation are amplified because economic agents must then make pricing and purchasing decisions under uncertain conditions. Instead of simply building a known inflation factor into their prices, market participants must adjust for inflation risk. While sellers can readily take steady inflation into account in setting prices and determining the future costs of inputs, variable inflation makes it difficult to know the real value of any nominal deal. This effect is reflected, for example, in the fact that both equity capital and loans are priced with a risk premium to capture the uncertainty of future inflation. Some empirical evidence indeed suggests that policies that reduce inflation variability are likely to promote economic growth (Elder 2004), independent of the inflation level.
The Role of Monetary Policy in Inflation
"Inflation is always and everywhere a monetary phenomenon," argued the Nobel Memorial Prize-winning economist Milton Friedman. What he meant was that general and sustained inflation can come about only through a faster increase in the quantity of money than in economic output. The relationship between the money supply and inflation is one of the crucial principles of macroeconomics.
In the short run, the money supply and inflation can diverge from one another: An increase in the money supply will not instantly lead to an increase in prices. Because prices are often "sticky" in the short run — it may be costly for firms to change their prices, and it takes time for firms to determine where to set their prices — easy money will cause output growth to increase temporarily. If economic growth was previously flat or below its long-run sustainable level, this temporary increase in growth will push the economy's growth closer to its sustainable level or even higher than its sustainable level.
In the long run, however, prices gradually will adjust upward in response to an increase in the money supply. Some market participants will react to increasing nominal demand by raising the prices at which they sell goods and services, including those of inputs to other firms. Firms that then experience input price increases will follow with their own price increases in an attempt to maintain their markups. In addition, workers facing price increases likely will press for wage hikes. This is the process through which inflation takes hold.
Firms base their pricing decisions, and workers base their wage demands, in part on their expectations of future inflation. Thus, the higher that inflation rises, the more difficult it is to change those expectations, and the more painful the process of bringing inflation back down. For example, when the Fed under chairman Paul Volcker adopted a tight monetary policy in late 1979 in response to high inflation, the result was a deep recession in 1981-82. High unemployment persisted afterward, exceeding 10 percent from September 1982 to June 1983. (There was also a shorter-lived recession in 1980 that is typically attributed to President Carter's credit-control program rather than monetary policy.) Hence, policymakers must be careful to avoid loose monetary policy, especially when the economy is operating at or near its long-run sustainable level, in which case it is likely to quickly induce inflation.
Part of the problem faced by the Fed in the early 1980s was a lack of credibility. Because the public was not convinced, after years of high inflation, that the Fed would maintain its tight-money policy, prices were slow to adjust and economic growth fell dramatically. In light of the role of expectations in the process of inflation, price stability requires a credible commitment by monetary authorities (Mehra and Reilly 2008; Lacker 2007; Broaddus and Goodfriend 2004).
One mechanism for achieving such credibility is a regime of "inflation targeting." The central bank adopts a target inflation rate and publicly commits to achieving that target — and to addressing departures from the target rate with strong monetary action, if necessary. If the central bank can credibly announce an inflation target, and thereby overcome the inflation expectations that will otherwise be created by short-term fluctuations in inflation, the central bank will be better able to maintain price stability and economic growth (Hetzel 2005; Lacker 2005). The United Kingdom, Canada, Sweden, and New Zealand have generally had greater price stability since adopting inflation targeting in the early 1990s (Roger 2009; Fregert and Jonung 2008).
On January 25, 2012, the Federal Open Market Committee (FOMC) announced a long-run goal for inflation of 2 percent. In its announcement of the policy, the FOMC said that it believed an explicit inflation target would help to "keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances." Even prior to the announcement, many observers had long believed that the Fed had a regime of implied inflation targeting.
While monetary policy is the product of collective decisions by the FOMC's voting members, each of whom may hold a different view on the optimal inflation rate, the Fed has consistently pursued anti-inflation policies for several decades. The credibility that the Fed has won in this regard is a valuable asset in pursuing its statutory goals of stable prices, maximum employment, and moderate long-term interest rates (Mehra and Herrington 2008).
Richmond Fed Research
Broaddus Jr., J. Alfred and Marvin Goodfriend. "Sustaining Price Stability." Federal Reserve Bank of Richmond Economic Quarterly, Summer 2004, vol. 90, no. 3, pp. 3-20.
Hetzel, Robert L. "What Difference Would an Inflation Target Make?" Federal Reserve Bank of Richmond Economic Quarterly, Spring 2005, vol. 91, no. 2, pp. 45-72.
Lacker, Jeffrey M. "Comments on 'Understanding the Evolving Inflation Process.'" Presentation at U.S. Monetary Policy Forum, Washington, D.C., March 9, 2007.
Lacker, Jeffrey M. "Inflation Targeting and the Conduct of Monetary Policy." Speech at the University of Richmond, Richmond, Va., March 1, 2005.
Mehra, Yash P. and Devin Reilly. "Inflation Expectations: Their Sources and Effects." Federal Reserve Bank of Richmond Economic Brief 08-01, October 2008.
Mehra, Yash P. and Christopher Herrington. "On the Sources of Movements in Inflation Expectations: A Few Insights from a VAR Model." Federal Reserve Bank of Richmond Economic Quarterly, Spring 2008, vol. 94, no. 2, pp. 121-146.
Andrés, Javier and Ignacio Hernando. "Does Inflation Harm Economic Growth? Evidence for the OECD." National Bureau of Economic Research Working Paper No. 6062, June 1997. (Abstract available online.)
Bruno, Michael and William Easterly. "Inflation Crises and Long-Run Growth." Journal of Monetary Economics, February 1998, vol. 41, no. 1, pp. 3-26.
Dotsey, Michael and Pierre Daniel Sarte. "Inflation Uncertainty and Growth in a Cash-in-Advance Economy." Journal of Monetary Economics, June 2000, vol. 45, no. 3, pp. 631-655. (Abstract available online.)
Elder, John. "Another Perspective on the Effects of Inflation Uncertainty." Journal of Money, Credit and Banking, October 2004, vol. 36, no. 5, pp. 911-928. (Manuscript version available online.)
Fregert, Klas and Lars Jonung. "Inflation Targeting Is a Success, So Far: 100 Years of Evidence from Swedish Wage Contracts." Economics, October 2008, vol. 2, no. 2008-31, pp. 1-25.
López-Villavicencio, Antonia and Valérie Mignon. "On the Impact of Inflation on Output Growth: Does the Level of Inflation Matter?" Journal of Macroeconomics, September 2011, vol. 33, no. 3, pp. 455-464. (Abstract available online.)
Roger, Scott. "Inflation Targeting at 20: Achievements and Challenges." International Monetary Fund Working Paper No. 09/236, October 2009.