The Dynamics That Can Drive Inflation

In the first half of 2011, spikes in food and gasoline prices strained the budgets of many Americans and sparked fears of more persistent inflation.

Nonetheless, the Federal Reserve expected such price spikes to be temporary and forecasted the overall inflation rate to stay in the neighborhood of 2.5% in 2011, with the core consumer price index (which strips out food and energy) to grow in the range of 1.5% to 1.8%.¹

The Fed focuses primarily on the core CPI — assuming it is a more accurate measure of long-term price movements — and aims to keep it near a target of 2% a year.

By that standard, consumers have experienced only moderate inflation over the last two decades. Many manufactured goods, such as clothing, computers, and many types of electronics, actually became much more affordable during this period.

Here’s a closer look at the reasons why some economists see the potential for higher prices in America’s future.

Emerging Economies

It’s possible that headline inflation, a broad measure that includes food and energy, may deserve more attention from policymakers going forward. Shocks can result in short-term periods of high prices for oil and food that may or may not spill over into other goods and services.

However, greater global demand for resources needed by developing nations could boost prices more regularly going forward. If so, focusing on core inflation might cause the Fed to systematically underestimate inflation for many years.²

Wholesale Prices

The Producer Price Index (PPI) measures price changes affecting businesses before they reach the consumer. Higher raw material costs have caused wholesale prices to increase faster than consumer prices over the last two years, but businesses may be more likely to pass some of the costs on to their customers as economic conditions and consumer confidence improve.³

Monetary Policy

Since the financial crisis began more than two years ago, the Federal Reserve has employed unprecedented methods to help keep borrowing costs low and stimulate the economy. Besides keeping interest rates near zero since December 2008, the Fed has undertaken two rounds of quantitative easing, essentially creating money to purchase $2.3 trillion worth of longer-term Treasury securities.⁴

The fear is that the Fed won’t move fast enough to raise rates and/or sell off the securities as the economy improves. There is also some concern that the federal government could fail to address ongoing budget deficits and may eventually resort to printing money to pay its creditors, which would most likely devalue the dollar further and could trigger higher inflation.

Other economists worry less about prices, believing there is still enough weakness in the economy (specifically depressed housing prices, high unemployment, and slow wage growth) that could continue to hold back consumer spending and possibly even cause inflation to fall.⁵

Investors should keep in mind the potential risk of inflation, whichever path it takes, because even modest price increases compounded over time can erode the purchasing power of the assets in their portfolios.

1) Reuters, June 22, 2011
2, 5) Bloomberg.com, May 24, 2011
3) Bloomberg.com, May 25, 2011
4) Reuters, May 19, 2011

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.