clock menu more-arrow no yes mobile

Filed under:

How economists know whether inflation is getting better

Inflation is starting to ease, but the United States is still a long way from the Federal Reserve’s goal.

Customers of a Las Vegas discount department store browse through racks of clothing on May 7, 2022.
Patrick T. Fallon/AFP via Getty Images
Madeleine Ngo covers economic policy for Vox. She previously worked at the New York Times, the Wall Street Journal, Bloomberg, and the Philadelphia Inquirer.

Although inflation is still running uncomfortably high and many Americans are struggling to keep up with rising prices, new data showed that price gains eased last month.

In October, prices rose 7.7 percent from a year before, according to a Consumer Price Index report released on Thursday. That’s slightly down from the previous month, when prices were up 8.2 percent. Prices rose 0.4 percent from September to October, the same rate as the previous month.

The CPI report is closely watched by the Federal Reserve, which has aggressively raised interest rates since March to bring inflation under control. Thursday’s report could be encouraging news for the Fed, but officials have repeatedly said inflation is still too high.

The Fed’s goal is to keep prices stable, ideally with inflation levels at about 2 percent annually over time. It isn’t to reverse inflation: the central bank is wary of deflation, or falling price levels, which can hurt economic growth. If overall prices are declining, consumers could pull back on spending because they expect costs will be lower in the future. Decreased spending could lead to a slowdown in hiring and business investment, meaning that more workers could be laid off and wage gains could slow.

If Americans can instead expect prices to rise at a stable and low rate of around 2 percent, they can make better financial plans. But with inflation running at its highest levels in 40 years, the United States is still a long way from that goal.

So how do policymakers determine whether inflation is getting better? Although much attention is focused on the CPI report, the Fed’s preferred measure of inflation is actually the price index for Personal Consumption Expenditures, which covers a broader range of spending and is produced monthly by the Bureau of Economic Analysis.

The CPI index captures what consumers pay out-of-pocket for goods and services, while the PCE index covers spending by and on behalf of households, which includes nonprofit institutions that provide services to households. For example, that means that health care costs in the PCE index reflect consumers’ out-of-pocket expenses as well as costs covered by employer-provided insurance and government programs, while the CPI index only covers the direct costs to consumers. So in the PCE index, health care has a greater weight.

The central bank also considers average inflation over longer periods of time — ranging from a few months to a year or longer — because month-to-month data can bounce around. And beyond the headline inflation number, the Fed looks at subcategories in the data to determine whether price changes are temporary or longer-lasting.

One important measure is “core” inflation, which excludes volatile food and energy prices.

Economists closely watch “core” inflation

Food and energy prices can dramatically move up or down each month and might not reflect longer-term price trends, since those changes could be a result of temporary factors and reverse relatively quickly. If the Fed only looked at overall inflation, officials might think that general prices are rising or falling more rapidly than they really are. In October, core CPI rose 0.3 percent, down from 0.6 percent the month before. (In September, core PCE rose 0.5 percent from the month before.)

Economists are closely watching what happens to core goods and core services, said Julia Coronado, the president and founder of MacroPolicy Perspectives. Earlier during the pandemic, consumers ramped up spending on goods like exercise bikes and work-from-home equipment. The spike in demand for goods, along with supply chain disruptions, helped lead to the rapid run-up in prices.

Now, consumers are shifting spending away from goods and back to services, which has resulted in price gains for goods starting to cool, Coronado said. Fed officials are watching whether that trend will continue, especially as pandemic-related supply issues ease, she said.

The Fed is also monitoring inflation for services like rents, which make up a large portion of core inflation and a significant chunk of household budgets. Private-sector data suggests that rent prices are already starting to cool, but reporting lags mean that it will take time for that to be reflected in government data. While easing rent prices would be welcome news for the Fed, officials would likely also want to see inflation for other services moderate before pausing their rate hikes, Coronado said.

“You’d need to see cooling in the other two — the core goods and the core services excluding rent,” Coronado said. “If you get that, then that’s very good news for their inflation battle.”

Although Fed officials are paying close attention to core inflation, they’re still weighing food and energy prices because they can impact people’s expectations about future inflation, said Omair Sharif, the founder and president of research firm Inflation Insights. Even though the Fed can’t do much to address supply-related issues, Sharif said officials want to see relief in food and gas inflation because they affect many consumers’ daily lives.

Categories such as used cars have seen price declines in recent months, but officials want to see a broader slowdown and improvement in more than just one or two categories, Sharif said.

“Even though I think some of that momentum is starting to cool off, especially on the goods side, there are still too many components that are showing too much strength right now,” Sharif said. “They’re going to want to see more of these items really come back down below that 4 percent level.”

Your expectations about inflation matter

Economists also track inflation expectations, which is the rate at which people expect prices to rise in the future. That ends up affecting actual inflation because consumers, businesses, and investors could change their spending behavior today based on what they think will happen to prices in the future.

That could become a problem for policymakers because it could lead to a “wage-price spiral” — a prolonged loop in which price increases lead to higher wages, which then puts even more pressure on inflation. If consumers are paying more for goods and services, they could demand higher wages from their employers. If businesses respond by increasing wages, they might continue to increase the prices that consumers pay to cover steeper labor costs.

Even if the Fed tries to counteract that, it can be a painful cycle, said Wendy Edelberg, the director of the Hamilton Project and a senior fellow in economic studies at the Brookings Institution. Edelberg said, however, that there isn’t evidence to suggest the country is now experiencing a wage-price spiral.

“We don’t see wages and prices moving in lockstep like that,” Edelberg said. “The hope is that wage growth is slowing partly because the labor market is cooling and partly because firms are not setting significant wage growth in anticipation of high inflation going forward.”

In October, average hourly earnings rose 4.7 percent from a year before, down from 5 percent the previous month. Even though wage growth has started to slow, inflation is still outpacing wage growth, making it harder for consumers to keep up with rising prices.

Jerome Powell, the chair of the Federal Reserve, said at a November 2 press conference after the Fed’s last meeting that data on longer-term inflation expectations suggested they remained “well anchored,” but that policymakers should not become complacent because “the longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation will become entrenched.”

According to data from the University of Michigan, long-term inflation expectations picked up slightly in October but have remained relatively stable this year. Last month, consumers expected prices to rise at an annual rate of 2.9 percent over the next five years, compared to 2.7 percent in September.

Fed officials have repeatedly tried to reassure the public that they’re determined to stamp out inflation, even if that means the country could tip into a recession. Powell has argued that it would be worse to prematurely loosen policy and allow inflation to become a more permanent fixture of the economy.

Labor market data plays a key role

Beyond the inflation numbers, the Fed considers a wider set of data, including on the country’s gross domestic product and global economic conditions. But labor market conditions are especially important to policymakers.

The Fed has two mandates: price stability and maximum employment. That means the Fed tracks labor market data to ensure that employment is still strong, even as it tries to weaken the economy to get inflation under control. Labor market data can also help officials better understand factors that might be driving up inflation.

Fed officials have repeatedly said the labor market is unsustainably hot and that it will likely need to slow further for inflation to meaningfully come down. Powell has pointed out, for instance, that the number of job openings is still high. At 10.7 million job openings, there are nearly two openings for every unemployed person in the country, reflecting the difficulties that businesses continue to face in filling their open positions.

“Although job vacancies have moved below their highs and the pace of job gains has slowed from earlier in the year, the labor market continues to be out of balance, with demand substantially exceeding the supply of available workers,” Powell said at the November press conference.

Although the unemployment rate rose slightly last month to 3.7 percent, it still remains near a half-century low. Job growth is also starting to slow compared to earlier in the year, but employers still added a robust 261,000 jobs to the economy in October. Layoffs are still well below pre-pandemic levels and initial jobless claims remain low.

Bill English, a former director of the monetary affairs division at the Fed and an economist at Yale University, said the central bank would prefer to see a more sustainable labor market in which employment is high, but there isn’t intense pressure on firms to raise wages to entice more workers. If demand for workers is too high and out of balance with the supply of labor, both wages and prices could be pushed up, generating more inflation.

But the Fed also risks weakening the labor market too much. As the Fed raises interest rates and makes borrowing money more expensive, officials are purposely trying to slow the economy and get consumers to buy fewer goods and services. That should help slow price gains, but that could cause a spike in unemployment. If demand drops, businesses could respond by hiring fewer workers or laying them off.

Fed officials have signaled that they could begin to slow the pace of rate increases as soon as next month, but they’ve cautioned that no decision has been made. Some investors and economists have grown wary in recent months that the central bank could end up raising rates too much and cause a painful economic downturn.

Data lags make it difficult for the central bank to see the full impact of its rate hikes immediately, and it takes time for the effects of monetary policy to ripple through the economy, creating a challenge for officials, English said. Still, he said the Fed would rather risk doing more now rather than wish they had done more sooner.

“What they’ve done at least so far seems to me to be about right, but it is a very tough situation,” English said. “There’s no question that they could end up in a bad place a year from now.”

Sign up for the newsletter Today, Explained

Understand the world with a daily explainer plus the most compelling stories of the day.