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2012 Annual Report

Inflation Did Not
Follow a Straight Path

Inflation took a bit of a rollercoaster ride in 2012, but overall price levels remained under the Fed's 2 percent inflation target. Although inflation is projected to stay at or below 2 percent, Fed policymakers remained vigilant on price pressures.

The headline rate of inflation went on a bit of rollercoaster ride over the year. (Headline inflation includes all prices, including volatile energy and food prices.) Price levels were up in the first quarter, driven largely by a rise in energy prices. Then in the second quarter, headline inflation plunged when the price of energy fell. The personal consumption expenditure (PCE) price index, produced by the U.S. Bureau of Economic Analysis, rose at a 2.5 percent annual rate in the first quarter, then fell 0.7 percent in the second quarter, and rose at a 1.6 percent rate in the third and fourth quarters. Overall, at 1.6 percent on a year-over-year basis , inflation remained under the 2 percent target set by the Federal Open Market Committee (FOMC). Looking through the monthly and quarterly fluctuations in prices, the overall trend for inflation in 2012 seemed to be one of disinflation.

Watch senior economist Mike Bryan and senior economic research analyst Nick Parker discuss the ups and downs of inflation.(see the video)

The core PCE price index, which excludes the volatile food and energy components, was steadier but ultimately took the same road as headline inflation. Core inflation moderated over the year, ending the year at 1.6 percent, a little under the Fed's longer-term objective.

Despite the sometimes wide fluctuations in price levels, inflation expectations remained well-grounded in 2012, according to survey findings and financial market measures. Monetary policymakers closely monitor the public's inflation expectations because those expectations can influence actual inflation rates.

Considerable slack in the economy contributed to low inflation, as did relatively stable commodity and import prices later in the year.

The Fed became an inflation-targeting central bank

Early in 2012, the FOMC formalized what had been an implicit inflation objective when it set an explicit 2 percent objective to the PCE price index over the longer term. In doing so, the Federal Reserve joined the ranks of many other central banks, including the Bank of England and the Bank of Canada, that have made explicit an inflation objective. The 2 percent inflation objective represents the level of inflation over the longer term that FOMC members view as most consistent with stable prices. Having an explicit target should help "keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates," explained the committee in its January 2012 statement. Firm inflation expectations also enhance the central bank's ability to pursue maximum employment "in the face of significant economic disturbances," the statement continued.

Fed remains vigilant on inflation risks

Inflation made the news again in December 2012, when the FOMC said it would keep the benchmark federal funds rate near zero as long as the unemployment rate remains above 6.5 percent, inflation over a one- or two-year period ahead is below 2.5 percent, and longer-term inflation expectations remain well-anchored. In his December 2012 news conference, Chairman Bernanke noted that policy under the Fed's new guidance "will be fully consistent with continued progress against unemployment and with inflation remaining close to the Committee's 2 percent objective over the longer term."

In December 2012, the FOMC released its projections for inflation over the next two to three years. Most committee members anticipated that headline and core PCE inflation from 2013 to 2015 would be at or below the Fed's 2 percent target. Meanwhile, committee members' longer-run projections for core PCE inflation remained at 2 percent. Despite the relatively benign outlook for inflation, the Federal Reserve continues to closely monitor inflation and longer-term expectations. Inflation remains a longer-term risk factor that FOMC members consider when weighing the potential costs and benefits of FOMC policy decisions. For instance, a common concern related to the expansion in the Fed's balance sheet is that this expansion could cause inflation expectations to become untethered. Despite those concerns, however, FOMC members projected that inflation will stay at or below the Fed's longer-term objective.

BIE survey digs deeper into inflation issues

In addition to economic forecasts, household survey data, and information gleaned from financial markets, the Federal Reserve Bank of Atlanta has recently introduced a new measure of inflation expectations—a monthly Business Inflation Expectations Survey that polls a panel of approximately 350 southeastern business leaders representing every sector of the economy about their current business conditions, expectations for inflation over the short and long term, and the factors driving cost changes. Introduced in late 2011, this survey was created to shed light on the inflationary views of businesses, a constituency not previously polled for their inflation expectations.

Each month, in addition to standard questions, the BIE survey poses a "special question" that further explores aspects of the panels' pricing decisions or general business conditions.

The August and September 2012 special questions delved into the measurement of economic slack. The amount of economic slack matters to Fed policymakers because it provides an indication of how the economy is performing relative to its potential, which is instructive when crafting policies that encourage maximum employment and price stability.

The August 2012 question asked panel members about their ability to pass on a cost increase to consumers. Sixty percent of firms said they could pass along most of a 6 percent increase in unit costs, a significant change over the measure taken 10 months prior, when 37 percent of firms gave this response. These results could be interpreted multiple ways, but they seem to suggest a decrease in the amount of slack, a positive sign.

The September 2012 survey approached the measurement of slack more directly, asking the panel members to estimate how far their current sales levels were from "normal," which could be viewed as an individual firm's output gap. On average, panel members estimated that their sales levels were 7.5 percent below normal, just slightly above the Congressional Budget Office's (CBO) 6 percent estimate of the output gap.