The inflation rate responds to each phase of the business cycle. That’s the natural rise and fall of economic growth that occurs over time. The cycle corresponds to the highs and lows of a nation’s gross domestic product (GDP), which measures all goods and services produced in the country.
Business Cycle: Expansion and Peak
The business cycle runs in four phases. The first phase is the expansion phase. This is when economic growth is positive, with a healthy 2% rate of inflation. The Federal Reserve (“the Fed”) considers this an acceptable rate of inflation. On August 27, 2020, the Fed announced that it would allow a target inflation rate of more than 2% if that will help ensure maximum employment. It still seeks a 2% inflation over time but is willing to allow higher rates if inflation has been low for a while. As the economy expands past a 3% rate of growth, it can create an asset bubble. That’s when the market value of an asset increases more rapidly than its underlying real value. The second phase of the cycle is known as the “peak.” This is the time when expansion ends and contraction begins.
Business Cycle: Contraction and Trough
As the market resists any higher prices, a decline begins. This is the beginning of the third, or contraction, phase. The growth rate turns negative. If it lasts long enough, it can create a recession. During a recession, deflation can occur. That’s a decrease in the prices of goods and services. It can often be more dangerous than inflation. As the economy continues its downward trend, it reaches the lowest level possible for the circumstances. This trough is the fourth phase, where contraction ends and economic expansion begins. The rate of inflation begins to increase again, and the cycle repeats. During recessions and troughs, the Fed uses monetary policy to control inflation, deflation, and disinflation.
The Effect of Monetary Policy
The Fed focuses on the core inflation rate, which excludes gas and food prices. These volatile prices change from month to month, hiding underlying inflation trends. The Fed sets a target inflation rate of 2%. If the core rate rises much above that, the Fed will execute a contractionary monetary policy. The Fed can also lower the federal discount rate, which makes it cheaper to borrow money from the Fed itself. This is an attempt to increase demand and raise prices. Other tools that the Fed uses are:
Reserve requirements (the amount banks hold in reserves)Open market operations (buying or selling U.S. securities from member banks)Reserve interest (paying interest on excess reserves)
U.S. Inflation Rate History and Forecast
The best way to compare inflation rates is to use the end-of-year consumer price index (CPI), which creates an image of a specific point in time. The table below compares the inflation rate (December end-of-year) with the fed funds rate, the phase of the business cycle, and the significant events influencing inflation. A more detailed forecast is in the U.S. Economic Outlook. A healthy rate of inflation is good for both consumers and businesses. During deflation, consumers hold on to their cash because the goods will be cheaper tomorrow. Businesses lose money, cutting costs by reducing pay or employment. That happened during the subprime housing crisis. In galloping inflation, consumers spend now before prices rise tomorrow. That artificially increases demand. Businesses raise prices because they can, as inflation spirals out of control. When inflation is steady, at around 2%, the economy is more or less as stable as it can get. Consumers are buying what businesses are selling. 1971–1989: Federal Reserve Bank of New York. “Historical Changes of the Target Federal Funds and Discount Rates,” Used to estimate targeted fed funds rate. 1990–2002: Board of Governors of the Federal Reserve System. “Open Market Operations Archive.” 2003–2022: Board of Governors of the Federal Reserve System. “Open Market Operations.”
