by Zain Jaffer
Inflation is a silent tax that affects everyone, but the greatest negative impact is to the poor. For the rich, it may mean cutting back on vacations abroad. But for the poor, it may mean not being able to pay rent, buy groceries, or other basic necessities.
Given the impact of the Fed rate hikes vis a vis its goal of two percent inflation to help it in its mandate of price stability and maximum employment, perhaps it is instructive to delve into how they compute inflation.
What is inflation anyway? It is the general increase in the average prices of all the goods and services in the economy.
Generally the Fed has two tools at its disposal. Raising or lowering the interest rates used by banks for debt affects mortgages, car loans, credit card, and other consumer debt. Yields on bonds on both short and long term bonds affect the demand, and market value of these bonds vis a vis the appetite for risk assets like stocks and risky projects like expensive real estate projects.
The second tool is to either quantitatively ease or tighten. If they ease, this means that they will buy the bonds and mortgage backed securities from banks, hold it in their books, and release cash to the banks so they have the liquidity to lend money out. If they tighten, it is the opposite. They won’t buy bonds or MBS, so the banks have less money to lend out.
The Fed monitors several different price indexes. Each price index measures a different group of goods and services, which are all computed differently. Therefore, various indexes can send diverse signals about inflation. For example, housing could be impacted by the price of lumber and other construction materials. Energy would of course include the price per gallon of gasoline. For food, most households would probably be buying milk and eggs, and so forth.
The Fed has also decided that a two percent annual target increase in the Department of Commerce’s Personal Consumption Expenditures (PCE) index is optimal for their mandate for maximum employment and price stability. The Fed FOMC uses the PCE price index as it covers a wide range of household spending. However, the Fed also monitors the Department of Labor’s Consumer Price Index (CPI) and Producer Price Index (PPI).
In addition, the Fed also considers the following. Because inflation can go up and down monthly, they generally prefer to average out over longer periods of time, from a few months or longer.
Also they regularly check the behavior of the components of a particular price index to help determine if the rise in inflation is driven by price increases (or decreases) of certain items which are likely to be temporary or unique events. For example, if there is a dockworkers strike that impact the prices of components for automobiles but it is projected to last only a month, then the impact of those may smoothen out over time as the port operations stabilize. The price of natural gas during winter increases but decreases during the summer months. Inflation due to more energy for heating will not last when the warmer months come.
The Fed tries to measure only core inflation to help it identify inflation trends. This means they avoid items that have large volatile swings in prices. Although food and energy are an important part of most household budgets, these are not used for core inflation measurements.
The Fed can only change monetary policy to fix the economy using the two tools at its disposal, namely interest rates and quantitative tightening or easing. It cannot control the fiscal spending of Congress, which has a huge effect on inflation.
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