Inflation Stays in Check

5 Reasons Why Inflation is at Bay

Inflation Stays in Check
November 28, 2014

Since the onset of the Great Recession between 2007 and 2009, the annual inflation rate in the U.S. has not risen above 3 percent. Moreover, it has not even risen to 2 percent over the past two years, clocking in at 1.5 percent in 2013 and 1.7 percent in 2012.

The Federal Reserve generally strives to maintain an annual inflation rate of between 2 to 3 percent, such as in 2007, when annual inflation was 2.8 percent. During the years preceding the Great Recession, meanwhile, the annual inflation rate was 3.2 percent and 3.4 percent.

These stats are cited to demonstrate just how low inflation has been in the U.S. since the recession. However, given the huge amounts of money that the Fed has poured into the U.S. economy since the recession to try to stimulate it, the $64,000 question is: why is inflation remaining so low?

The Cycle of Inflation

Under normal circumstances, when money is pumped into the economy by the Fed, this tends to result in higher inflation. The Fed has injected trillions of dollars into the U.S. economy over the past few years.

As NPR host Renee Montagne put it during a recent segment of Morning Edition, “The Fed has created trillions of dollars out of thin air.” Montagne’s guest on the program, Jacob Goldstein, offered what he called the classic Econ 101 explanation for inflation: “Too much money chasing too few things.”

For example, suppose people buy more new cars with the extra money that has been printed by the Fed. Due to supply and demand, this should enable car dealers to raise their prices and thus give their employees raises. Employees can then use this extra money to go out and buy more goods and services, which enables other companies to raise their prices as well.

However, this cycle of inflation has failed to materialize so far, despite all the money that has been pumped into the U.S. economy. The M1 measure of money supply has gone up 70 percent over the past five years, while the U.S. monetary base has tripled.

Possible Explanations

Economists differ on their opinions of exactly why inflation has stayed in check despite the Fed’s ongoing easy money policy. However, here are five possible explanations:

  1. Too much money is sitting idle in banks. In the NPR interview, Goldstein noted that banks are still hesitant to lend money, even six years after the financial crisis ended. Therefore, much of the extra money that has been injected into the economy by the Fed is not being used to stimulate the economic activity that would naturally lead to inflation.

  2. Family incomes are stagnant. At the same time, wages and household incomes have been stagnant when adjusted for inflation since before the recession, reducing family buying power. When people cannot afford to buy more goods and services, they buy less of them, which keeps a lid on prices.

  3. Interest rates remain low and economic growth remains sluggish. Meanwhile, interest rates are still at or near historic lows and economic growth is well below what the U.S. has experienced in most other post-recession recoveries. In a recent essay, economists at the Cleveland Fed attributed half of the cause of low inflation to slower-than-expected growth and stubbornly high unemployment that “put downward pressure on inflation.”

  4. Most people aren’t worried about inflation right now. Interestingly, people’s perceptions of inflation actually affect what happens with inflation. While most people tend to believe that food and gas prices are rising — despite the recent drops in oil prices and corresponding fall in the price at the pump — they don’t generally see overall inflation as a pressing concern right now.

    This tends to affect people’s buying behavior. When people think that prices will rise in the future, they often rush out to buy things now while they are less expensive. However, if they think inflation is low, they aren’t in a hurry to buy, especially big-ticket items like automobiles. Therefore, sales slow, which inhibits companies from raising prices.

  5. Labor costs, import and energy prices, and other temporary factors. In the Cleveland Fed essay, the economists attributed 25 percent of the cause of low inflation to labor costs and import and energy prices and another 25 percent to what it called “temporary factors,” like a sharp slowdown in healthcare inflation.

    In testimony before Congress, Fed Chairwoman Janet Yellen also noted temporary factors as a cause for low inflation: “Some of the factors contributing to the softness in inflation over the past year, such as the declines seen in non-oil import prices, will probably be transitory. Importantly, measures of longer-run inflation expectations have remained stable,” she noted.

Why It Is Important

Understanding why inflation has remained low despite massive injections of liquidity into the economy is important because it will help the Fed set monetary policy for the U.S. going forward. For example, the president of the Chicago Fed recently said that the Fed should keep short-term interest rates low for a longer period if inflation stays in the one percent range.

Keep your eye on such economic factors as the money supply, unemployment rate, interest rates and overall economic growth as you gauge what could possibly happen with inflation going forward.

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