If Inflation is Going Down, Why are (Some) Prices Still High?

This post is, in part, motivated by a recent Chicago Fed Letter about the US consumer’s “persistent pessimism” in the wake of the Covid-19 pandemic. By most measurements, the economy is doing pretty darn well: unemployment is low, US real GDP grew 4.9% in the third quarter, and inflation is in decline. So why do so many Americans rate the economy as poor?

Well, one of the more obvious pain points is the price level, an average measure of the price of a bundle of goods measured against some index. The Consumer Price Index (CPI) is probably the most familiar: when you read about inflation numbers, most measurements use the CPI in its calculations. When we talk about inflation, we are talking about a rate of change in prices. So the price level is a measurement, and inflation is measuring the pace at which that measure is changing.

And while the rate of inflation is declining -- prices are increasing at a slower rate -- that does not necessarily mean the price level has declined. This may sound alarming, but it’s actually normal. Prices are “sticky,” or slow to respond to changes in the economic environment.

Here’s why:

1. Economic conditions determine the level of demand in the economy, i.e. how much stuff people want to spend money on. When the economy heats up, demand goes up, and people spend more.

2. So, firms agree to produce more stuff to meet the higher level of demand. But there are costs involved to expand their production: the firms may enter contracts, or buy more machines, or hire more labor in order to meet demand. And in reality, firms adjust their prices to account for these costs.

3. Now, if economic conditions change, and the quantity demanded falls, firms still have the “stuff” they paid for to produce at the old, higher level of demand. It takes time to absorb or reduce these costs, so prices remain elevated for a while even though consumer demand has decreased.

4. So, prices are sticky. So is inflation. Both take time to adjust.

Interestingly enough, without this friction, central banks wouldn’t be able to moderate inflation through interest rates. Basically, the Fed supplies whatever quantity of money is demanded at their targeted interest rate. We can think of the interest rate as the opportunity cost of holding money: what you give up by holding cash or spending money instead of saving it.

At higher interest rates, the opportunity cost of holding money goes up, so people save more money in accounts where they earn a return, reducing the quantity of money demanded in the economy – they buy less stuff, hold less cash, and save more. Because the quantity of money demanded goes down, the quantity of money supplied by the central bank also goes down.

And because of the “stickiness” we talked about earlier and the costs firms incur in the production process, prices don’t immediately respond to these changes. But over time, firms adjust their costs and their prices. People are spending less money, so firms adjust their prices downward to meet that lower level of demand. This lowers the price level, but it takes a while. And all this is a big part of why prices are still elevated even though inflation itself is declining. It’s part of the economy’s transition dynamics, which take time.

Now, this is a simplified explanation… the economy has a LOT of moving parts! But we hope you enjoyed our writeup, and as always, we are here if you want to get in touch.

Any opinions are those of the author and not necessarily those of Raymond James. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making a decision, and it does not constitute a recommendation. All opinions are as of this date and are subject to change without notice.