Surprising Inflation

The pain of high gas prices might still be fresh in your memory, but did you know that inflation was lower in 2006 than the previous year? For the 12 months ending in December 2006, inflation rose a mere 2.54%, almost one percentage point lower than 2005's reading and well below the 4% annual average of the past 50 years, according to Thomson Financial. But it's also above the 1% to 2% rate preferred by the Federal Reserve, which still sees inflation as the predominant risk to the U.S economy.

Inflation is usually reported as a single number, but many components (including energy prices) go into calculating the inflation rate. By understanding the ways in which economists and policymakers look at inflation, you may be able to understand the differences between what the news says and what your experience tells you.

Inflation is measured in several ways. Two of the most common and easy-to-understand measurements are the Consumer Price Index (CPI) and the Producer Price Index (PPI). Each of these indexes considers many kinds of prices. The CPI looks at retail prices for such common items as food, clothing, shelter, fuel, medical costs and other goods and services that people rely on for daily needs. The PPI looks at wholesale prices for some of the same items, plus several others.

When economists evaluate these two indexes, it is common practice to look at both overall inflation and “core” inflation, which excludes food and energy prices. Here’s why. Food and energy prices are typically more volatile than other prices. Although we tend to think of volatility as describing rising prices, it also describes falling prices. Food prices are more volatile because weather can cause problems; energy prices are affected by changing geopolitical and market conditions.

For example, when there is a spike in energy prices but prices quickly correct, the higher prices may not become embedded in the prices of goods and services that rely on energy – that is, if merchants believe that higher energy prices are temporary, they may decide not to raise their prices even though their energy bills were higher. Thus, the higher prices will be reflected in the overall inflation rate but probably not in the core reading. If the price spike is prolonged, economists will look for evidence that higher energy prices have driven up other prices and influenced the core inflation rate. Sometimes such evidence can be found by comparing the overall inflation rate with the core inflation rate.

The core inflation rate was 2.57% in the 12 months ending in December 2006 (compared with the general inflation rate of 2.54% mentioned above). This rate slowed during each month of the fourth quarter, indicating that volatile energy prices had done little to affect other prices.

Aside from weakening the purchasing power of the dollar, inflation is also linked to the health of the economy and, by extension, interest rates. The Federal Reserve watches inflation closely because it can squelch a growing economy if it is allowed to grow too fast. When inflation appears to be increasing, the Fed may decide to raise certain short-term interest rates in order to remove liquidity from the economy. It accomplishes this essentially by reducing the money supply. If you remember the laws of supply and demand from Econ 101, then you know that decreasing the supply of something while the demand remains the same causes prices to rise. Because interest rates represent the price of money, a shorter money supply results in higher interest rates.

Although it might seem counterintuitive to keep prices down by raising the price of money, it is the Fed's preferred strategy for controlling inflation. When there is less money circulating, economic activity tends to slow, and the value of money tends to rise – the opposite of inflation.

It's easy to remember paying $3 or more for a gallon of gasoline last summer, but you may have paid less attention to recent oil prices, which plummeted toward the end of 2006 to levels not seen since 2005 (though they have risen steadily in past weeks). As of mid-January 2007, the price for a barrel of oil had fallen 33% from its record high of $78.40 per barrel set on July 14, 2006.

Even though the Fed would like to see an inflation rate below 2%, many economists don't expect policymakers to increase interest rates during the first half of 2007. (The annual inflation rate has been below 2% during just 13 of the past 50 years.) In addition to falling oil prices, there are other indications that price pressures are easing. Inflation can help indicate the direction of the economy and interest rates during the near future. Learning how to interpret news about inflation may provide clues about the next move for your portfolio.