Inflation is defined as a sustained increase in prices of goods and services. As an economy expands, consumers and businesses will spend more money on goods and services. Once the economy reaches the growth stage of an economic cycle, demand often outpaces the supply of goods, and producers are able to increase their prices. Consequently the rate of inflation begins to increase.Additionally, if the economy accelerates rapidly, supply is unable to keep up with demand, which causes producers to raise prices even higher.This is often referred to as “too much money chasing too few goods.” If the economy begins to slow, demand decreases and the supply of goods rise. As a result, the rate of inflation typically decreases. Such a period of falling inflation is known as disinflation. This is what the Federal Reserve (the Fed) has been concerned with for most of this year.

The two most popular tools for monitoring inflation are the Producer Price Index (PPI) and the Consumer Price Index (CPI). In addition, most economists, including the Fed, typically concentrate on the “core inflation,” which excludes food and energy prices, due to high volatility in prices. PPI measures prices paid to producers, usually by retailers. It is reported on a monthly basis, with approximately 75 percent of the index accounts for consumer goods, while capital goods prices make up the remainder. The PPI generally identifies up price trends relatively early in the inflation cycle. See chart 1 below for the rate of inflation (core), year-over-year, for producer prices over the past ten years. As for the CPI, it reflects retail prices of goods and services, including housing costs, transportation, and healthcare. See chart 2 below for the rate of inflation (core), year-over-year, over the past ten years.

Chart 1

Source: Bureau of Labor Statistics

Chart 2

Source: Bureau of Labor Statistics

The Fed attempts to control inflation by regulating economic activity. The main resource the Fed utilizes to “control” economic activity is by raising and lowering short-term interest rates. If the Fed lowers short-term interest rates they are in essence increasing the money supply by encouraging banks to borrow from each other and from the Fed. As a result, banks make more loans to consumers and businesses, which causes the economy to expand. As economic growth expands, so do inflationary pressures. If the Fed increases short-term rates it dissuades consumers and businesses from borrowing, which causes the money supply to decrease. As a result, economic activity slows down and inflation subdues. What the U.S. economy has experienced over the first half of this year was a dual policy mandate. That means that the Fed tried influencing economic growth through decreasing short-term interest rates to a 45-year low of 1%. Additionally, the government gave U.S. Americans one of the biggest tax cuts in U.S. history, coupled with an increase in government spending. The U.S. economy has turned the corner, growing at 7.2 percent in the third quarter and adding 126,000 jobs in October. We believe the economy will continue to grow at 4-5% throughout 2004 and continue adding jobs. As a result, inflation will begin to move from the 1.5-2% range to a more historic average (refer to chart 2) of 2-3% over the next 12 months.