In the early days of 2021, the outlook for inflation was peppered with words such as “mild” and “moderate.” Inflation, the year-over-year increase in consumer prices, was expected to rise but just slightly above its historic benchmark of 2%. Or so the story was told. But today, a different tone has been struck that leaves very little doubt on the current state of inflation.
With each passing week, economic data conveys just how far-reaching rising prices have become within our economy. The Consumer Price Index (CPI) shows that prices on consumer goods and services increased by 5% over the past 12 months, a 13-year high. Core CPI, which strips out the more volatile and seasonal food and energy prices, is at 3.8%, a 29-year high.
The Core Personal Consumption Expenditures Index, the Federal Reserve’s preferred measure of inflation, is at a 13-year high of 3.6%. The Producer Price Index reports that prices charged by manufacturers and producers of goods and services have increased by 6.6% over the past 12 months, a new record high. In the past year, import prices have increased by 11.5%, a 10-year high, while export prices have risen 17.4%, an all-time high.
One can argue these high inflationary numbers are somewhat skewed by the “baseline effect” – comparing current prices to the much lower prices in May 2020 at the height of the pandemic. But even when you remove the baseline effect from the equation, the results are clear. Prices continue to rise and at a much faster pace than the Federal Reserve was expecting.
The task for keeping inflation in check lies with the Federal Reserve. As part of its mandate, the Fed drives our nation’s monetary policy to manipulate spending, investment, employment and inflation to promote the health of our economy and financial system.
To prevent excessive inflation, the Fed has a number of tools within its arsenal. It could start to raise the fed funds rate, which serves as the benchmark for short-term interest rates. By raising interest rates, the Fed increases the cost of debt for consumers and businesses to buy goods and services on credit, such as credit cards and bank loans. This inherently reduces spending, which gently taps the brakes on rising prices.
The Fed could also begin tapering its Quantitative Easing (QE) program, where it’s been buying $120 billion of U.S. Treasury bonds and mortgage-backed securities each month. The effect of QE is to increase the money supply while driving down long-term interest rates. By gradually reducing its monthly purchases, the Fed would reduce the supply of money in the economy and begin raising interest rates, allowing for a measured decline in consumer prices.
At the conclusion of its June meeting on Wednesday, the Fed significantly ramped up its inflation forecast for the remainder of 2021. But the Fed reaffirmed its decision to take a much more passive approach to address rising prices – for now, at least, it won’t do much of anything. The Fed continues to assert the recent surge in inflation is a short-term, transient event. Consequently, at this time, no change to interest rates or its monthly purchase of bonds and government securities is needed.
Faced with surging inflation, the Fed is rolling the dice that even the mildest of adjustments to its current monetary policy simply isn’t needed. But this gamble carries sizable risks. If the Fed is wrong, which many on Wall Street contend, inflation won’t be a short-term prospect but a longer-lasting endeavor. If high prices persist, the Fed could then be forced to impose more sudden and drastic measures to rein in inflation. And those more severe measures could cause problems for the U.S. economy down the road.