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Inflation: Prices
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Inflation is often reported as a percent change in the overall price level between two periods as measured by a price index. This chart shows December to December changes over the past 53 years as measured by the Consumer Price Index (CPI), a popular measure of inflation in the U.S.. Notice that the rate of inflation varied considerably during the 1970s and into the early 1980s but has been relatively stable recently.
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In the years since World War II the United States has experienced almost continuous inflation, the only exception being very slight deflation in the early 1950s. The inflation rate was nonetheless quite moderate until the expansion of the Vietnam War in the late 1960s. A reluctant President Richard Nixon mandated a series of price controls from 1971 to 1974, but these did little to stem the tide of rising prices, particularly after an international oil embargo in 1973–1974 caused energy prices to skyrocket. Overall in the 1970s the consumer price index rose at an average annual rate of nearly 7.5 percent, compared with 2.7 percent per year in the 1960s. A sharp recession in the early 1980s coupled with activist monetary policy cut the inflation rate to an average of 4.6 percent between 1980 and 1990.Inflation fell further in the 1990s, to an average of 2.7 percent (1990–1999).
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Mortgage rates moved higher after two reports showed inflation could be an issue. In particular, both the Producer Price Index and Consumer Price Index showed larger than expected increases, even after excluding volatile energy costs. The news was enough to push bond yields and mortgage rates higher. After all, inflation is like poison to bond investors as it erodes the value of the fixed payments they receive. Mortgage rates are closely related to yields on long-term government bonds.
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[T]he real estate boom in the 1970s was fueled in part by inflation-induced distortions, wrote Lynn Browne of the Boston Fed. High rates of inflation accelerated home buying by increasing the real, after-tax returns to investment in owner-occupied housing relative to alternative investments. A lag in interest rates reinforced this uptick in demand. As house prices in turn began to rise faster than the general price level, people rushed to buy rather than face higher prices later.
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Although acknowledging the possibility of "cost push", most Neo-Keynesians took up the demand-pull explanation of inflation. However, the Keynes-Smithies story was told almost completely in the context of income and expenditure, and ... surprisingly, ignored the monetary side. The Neo-Keynesians nonetheless attempted to appropriate the story into their IS-LM model by simply grafting on a capacity constraint, YF, to the left of the IS-LM-determined equilibrium, Y* and calling the resulting difference the "inflationary gap". With output stuck at YF, excess demand for goods will result in increases in the price level as before. However, unlike the Keynes-Smithies story, there is not a resulting "redistribution" of income to close the gap. Rather, as price level rises, the real money supply collapses and thus the LM curve shifts to the left and thus back to full employment output.
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The consumer price index (CPI) is the most widely used measure of inflation. The index is figured each month by computing the percentage of price changes for 80,000 different goods and services. The CPI is used as a benchmark for determining adjustments to new labor contracts, Social Security payments, and tax brackets. Some economists... believe that the CPI regularly overstates inflation by 1.5%.
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