Inflation and The Federal Reserve

From the Federal Reserve website:

Definition of Inflation

Inflation occurs when the prices of goods and services increase over time. Inflation cannot be measured by an increase in the cost of one product or service, or even several products or services. Rather, inflation is a general increase in the overall price level of the goods and services in the economy.

How The Federal Reserve Measures Inflation

Federal Reserve policymakers evaluate changes in inflation by monitoring several different price indexes. A price index measures changes in the price of a group of goods and services. The Fed considers several price indexes because different indexes track different products and services, and because indexes are calculated differently. Therefore, various indexes can send diverse signals about inflation.

The Fed often emphasizes the price inflation measure for personal consumption expenditures (PCE), produced by the Department of Commerce, largely because the PCE index covers a wide range of business and household spending. However, the Fed closely tracks other inflation measures as well, including the consumer price indexes and producer price indexes issued by the Department of Labor.

When evaluating the rate of inflation, Federal Reserve policymakers also take the following steps:

• First, because inflation numbers can vary erratically from month to month, policymakers generally consider average inflation over longer periods of time, ranging from a few months to a year or longer.
  
  
• Second, policymakers routinely examine the subcategories that make up a broad price index to help determine if a rise in inflation can be attributed to price changes that are likely to be temporary or unique events. Since the Fed's policy works with a lag, it must make policy based on its best forecast of inflation. Therefore, the Fed must try to determine if an inflation development is likely to persist or not.
  
  
• Finally, policymakers examine a variety of "core" inflation measures to help identify inflation trends. The most common type of core inflation measures excludes items that tend to go up and down in price dramatically or often, like food and energy items. For those items, a large price change in one period does not necessarily tend to be followed by another large change in the same direction in the following period. Although food and energy make up an important part of the budget for most households -- and policymakers ultimately seek to stabilize overall consumer prices -- core inflation measures that leave out items with volatile prices can be useful in assessing inflation trends.

The Federal Open Market Committee (FOMC) judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve's mandate for price stability and maximum employment. Over time, a higher inflation rate would reduce the public's ability to make accurate longer-term economic and financial decisions.

On the other hand, a lower inflation rate would be associated with an elevated probability of falling into deflation, which means prices and perhaps wages, on average, are falling--a phenomenon associated with very weak economic conditions. Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken. The FOMC implements monetary policy to help maintain an inflation rate of 2 percent over the medium term.

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