As of February 2011, the Consumer Price Index has gone up 2.1 percent in the preceding 12 months. Core inflation (All items excluding Food and Energy) went up just 1.1%. Inflation is certainly not beating at the door. On the other hand, global food commodity prices have been rising suddenly as have oil prices. In class we talk about how the All Items CPI is important, but that the Core CPI is a better measure of broad-based changes in prices.

The modest inflation measures will change in the future. We almost certainly should expect prices to rise more rapidly. We just don’t know when, or for how long.

Aggregate Demand and Aggregate Supply

This blog post by economist Tim Duy has a very thorough and clear explanation of some of the forces gathering on the inflationary front. He presents this as a way to help understand the decisions and debate within the Federal Open Market Committee (FOMC) in the months to come. Though clear, his explanation requires an understanding of aggregate demand and aggregate supply curves. So, for my students, mark this post and come back to it once we’ve covered those subjects.

For any reader, here are the summary conclusions that Duy reaches:

We can track the path of the prices and output and explore the positions of Fed officials within a fairly simple framework.  That framework suggests that the economy will experience a temporary period of accelerating inflation as it returns to potential (we should be so lucky, quite frankly).  There doesn’t seem to be much debate at what speed this will occur; Fed officials appear comfortable with growth expectations around 3.7% this year.  What does seem to be an issue of debate is the size of the unemployment gap.  If we are close to the natural rate of output, excess monetary stimulus is close to triggering the fabled wage-price spiral.  If far away, there is plenty of excess capacity and thus no need to tighten quickly.  Indeed, tightening policy too soon would only entrench disinflationary expectations.  Fed officials appear to be splitting along these two basic views of the world, with one side seeing recent price increases as consistent with their inflationary nightmares.  I tend toward the other, which I also think will be the dominate view at the FOMC.

And here is my translation:

• The Fed expects economic growth to continue, and even at a somewhat faster pace.
• Our regular models suggest that this continued growth will put upward pressure on prices.
• One big unknown is whether there is a lot of unused capacity in our economy – particularly among workers.
• If there are a lot of workers who can be put back into production, without much training, we have plenty of unused capacity which will soften inflation.
• If those workers who are still unemployed have the wrong skills or geographic location, our unused capacity is smaller.
• As we use up our capacity and get closer to full economic production, we get closer to the danger of a wage-price spiral that would cause inflation to increase significantly.
• Some members of the FOMC fear we are close to capacity and that any more moves to stimulate the economy will trigger that wage-price spiral.
• Other members of the FOMC are less worried about inflation and instead fear that a cutback in stimulus efforts will stall the recover.
• Duy predicts that the inflation hawks (the first group) will be outvoted by those worried about recovery.

For my students – this is a bit more complicated than we handle in a Principles class, but a good way to test your understanding of aggregate demand and aggregate supply.