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Annual Report 2023 | Federal Reserve Bank of St. Louis

Annual Report 2023

Federal Reserve Bank of St. Louis

Prices, Wages and Workers: The Recent U.S. Inflation Experience

By Fernando M. Martin and David C. Wheelock

Inflation was the economic story of 2023 and the two preceding years. After more than a decade of relatively stable prices, U.S. inflation began to rise in 2021 on the heels of the COVID-19 pandemic, then peaked in mid-2022 before declining.

The main essay of the Federal Reserve Bank of St. Louis’ 2023 annual report focuses on various aspects of inflation. This overview defines inflation and examines different views about its causes. It reviews the rise and fall of inflation after the COVID-19 pandemic shock in 2020 and describes how the Federal Reserve used the tools at its disposal to bring down inflation. The balance of the essay highlights the research of three St. Louis Fed economists whose work helps to explain or forecast inflation and its broader effects on the economy.

What Is Inflation, and How Is It Measured?

Consumers naturally focus on the prices of goods and services they buy and might associate inflation with increases in the prices of one or more of those items. However, to economists, inflation refers to a sustained increase in prices generally—not necessarily to all prices but to a wide range of prices throughout the economy. Economists use price indexes to measure changes in the aggregate price level and thus the rate of inflation.

Price indexes, such as the consumer price index (CPI), are composite measures of prices paid for goods and services throughout the economy. The CPI is a weighted average of prices of items in a basket of goods and services commonly purchased by urban American households, with the weights on individual prices reflecting the expenditure shares of each item. The rate of change in CPI over time is one measure of the inflation rate .

The CPI inflation rate is the most well-known measure of U.S. inflation. Certain government payments, such as Social Security benefits, are adjusted annually for changes in the CPI so that inflation does not erode the purchasing power of benefit recipients. Similarly, the interest and principal on certain marketable securities issued by the U.S. Treasury are adjusted annually to account for CPI inflation.

Other inflation measures, such as changes in the price index for personal consumption expenditures (PCE), are also popular. The Federal Reserve focuses on PCE inflation when setting monetary policy. Although both indexes are useful, the PCE price index includes a wider variety of expenditures than the CPI and is thought to better capture changing consumer spending patterns, and therefore might better reflect the true inflation rate . In recent years, the PCE inflation rate typically has been slightly lower than the CPI inflation rate, though their trends have been similar. A key difference between these two price indexes is that the CPI includes only out-of-pocket expenditures, whereas the PCE price index includes consumption expenditures regardless of how they are paid. (The difference matters for items such as health care.) In addition, housing costs have a significantly larger weight in the CPI than in the PCE price index.

Price Stability and the Federal Reserve’s Inflation Target

Consumers may find inflation frustrating at best, and possibly detrimental to their standards of living. Inflation, especially high or highly variable inflation, also interferes with the efficient functioning of the economy. Inflation can obscure the price signals that consumers and firms rely on when making their buying, saving and investment decisions. In turn, this can lead households and firms to make economic decisions that they would not have made if the price level was stable, such as using resources in an effort to protect themselves from inflation, which can slow the growth of the economy and living standards.

Recognizing the important role that monetary policy plays in determining the inflation rate over the medium to longer run, Congress made price stability one of the Federal Reserve’s main policy goals, along with maximum sustainable employment and moderate long-term interest rates. The Fed’s monetary policymaking committee, the Federal Open Market Committee (FOMC), has deemed that 2% inflation, as measured by the annual change in the PCE price index, is consistent with the price stability goal. Why 2%? It is a widely accepted international standard based on experience indicating that the economy performs well when the inflation rate remains close to 2%. Further, 2% inflation provides some room for the Fed to lower interest rates during periods when employment falls short of the maximum sustainable level. The FOMC’s statement on longer-run goals and monetary policy strategy (PDF) explains how the committee will respond to employment shortfalls and deviations from the 2% inflation target, and that it will take a balanced approach at times when its employment and price stability goals conflict.

What Causes Inflation?

“a monetary phenomenon”.

Economist Milton Friedman famously argued that “inflation is always and everywhere a monetary phenomenon.” See Milton Friedman’s “ The Counter-Revolution in Monetary Theory ,” Institute of Economic Affairs, 1970. In Friedman’s “monetarist” view, inflation is caused by excessive growth of the money supply, which generates more demand for goods and services than the economy can supply, and consequently prices are bid higher. In countries with low average inflation, however, such as the U.S., the relationship between growth of common money stock aggregates (such as currency and bank deposits) and inflation is not as tight as the theory would predict. However, expansions of the money supply in exigent circumstances, such as major wars, have been associated with a rise in inflation. See Kevin L. Kliesen and David C. Wheelock’s “ The COVID-19 Pandemic and Inflation: Lessons from Major U.S. Wars ,” Federal Reserve Bank of St. Louis Review , 2023.

Supply Shocks

Various non-monetary explanations for inflation also have been suggested. In the 1970s, for example, it was popular, even among central bankers, to blame inflation on rising energy and other costs and supply shortages. Although supply shocks and bottlenecks are unlikely to cause a persistent rise in the price level, transitory adjustment in the price level can continue for several months or quarters and thus raise the inflation rate for some time.

Unemployment: The Phillips Curve

Another popular explanation is associated with a perceived negative trade-off between inflation and unemployment known as the Phillips curve. Based on this theory, one might expect higher inflation as the economy strengthens and lower inflation as the economy weakens. This is the lens through which many central banks explain fluctuations of inflation around their targets. However, the data have offered weak support for a systematic relationship between inflation and real variables, including unemployment. From the mid-1990s through 2019, the Phillips curve was “flat”—that is, inflation was relatively stable, regardless of fluctuations in the unemployment rate. In contrast, since 2022, the Phillips curve has been “vertical,” with a low and stable unemployment rate, despite significant movements in the inflation rate.

Inflation Expectations

Although the monetarist view of a tight link between money supply growth and inflation is no longer widely held, many economists still accept that central bank policies have an important influence on inflation. A leading explanation maintains that central banks can control inflation over the medium to long term through policies and actions that anchor the public’s inflation expectations to the central bank’s inflation target. In this view, inflation is more likely to be low and stable if the public believes that the central bank is firmly committed to that outcome.

Fiscal Policy

A more recent theory of inflation is the fiscal theory of the price level, which links the overall price level and inflation to the level of government debt and expected future fiscal surpluses. This theory predicts higher prices as debt rises and higher inflation as the growth rate of debt increases. Predictions of the fiscal theory rely on a stable demand for government liabilities and, like the monetarist theory, have proved challenging to support empirically.

The high-inflation episode following the onset of the COVID-19 pandemic featured many of the elements mentioned above. On one hand, there was a significant increase in government debt, a substantial amount of which was purchased by the Federal Reserve. On the other hand, there were significant supply-side disruptions. Throughout the episode, short-term inflation expectations trailed actual inflation, while medium- and long-term expectations remained anchored near the Fed’s 2% target.

COVID-19 Pandemic Inflation

At the onset of the COVID-19 pandemic, the Federal Reserve adopted an accommodative policy stance to support the economy and smooth functioning of financial markets. Notably, the Federal Reserve cut its target range for the federal funds rate to near zero, opened multiple temporary liquidity facilities, and initiated purchases of mortgage-backed securities and U.S. Treasury debt on a large scale. During the early months of the pandemic, the overall price level declined as consumption demand fell, and 2020 ended with a low inflation rate.

Inflation then started to pick up during 2021. At first, inflation was widely expected to be short-lived and involved a relatively narrow group of goods and services. As the year went on, high inflation proved persistent and more generalized, leading the FOMC to tighten monetary policy with the purpose of returning inflation to its 2% target. For more on these topics, see Fernando M. Martin’s Oct. 19, 2021, On the Economy blog post “ How Widespread Are Price Increases in the U.S.? ” and his Oct. 17, 2022, On the Economy blog post “ Inflation Is Still High and Widespread .” The FOMC moved first to taper, or reduce the pace of, asset purchases in November 2021, which contributed to a rise in long-term interest rates. Then, in March 2022, it lifted the federal funds rate from zero and began a series of increases in its funds rate target range. Annual PCE inflation peaked in June 2022 at 7.1% and then fell throughout 2023, though it remained above the Fed’s 2% target at the end of 2023. The figure below shows the evolution of inflation and interest rates during this episode.

Annual Inflation Peaked in Mid-2022 as Interest Rates Rose

SOURCES: Bureau of Economic Analysis and FRED ® .

NOTES: Inflation is measured as the 12-month change in the PCE price index. The federal funds rate and the 10-year Treasury yield correspond to their monthly averages.

The table below breaks down inflation into four major categories and two aggregates. The major components are food, energy, core goods and core services. “Core” explains that the particular category excludes food and energy. These components account for roughly 8%, 4%, 22% and 66%, respectively, of total consumption expenditures. The two measures of aggregate inflation are those closely monitored by the Federal Reserve: PCE and PCE excluding energy and food prices (known as core PCE). The table shows inflation rates over several periods: 2016-19 (which was prior to the COVID-19 pandemic), 2020, 2021, 2022 and 2023.

Above, the table shows that inflation varied significantly across broad categories. Before the pandemic, food prices were stable and core goods prices were falling, but prices of energy and core services were rising above 2% at annual rates. Together, these numbers implied an overall, or headline, inflation rate of 1.7% annually during 2016-19, which was slightly below the Federal Reserve’s target.

All of the categories contributed to high headline inflation in 2021 and 2022, revealing the widespread nature of the phenomenon. In 2023, inflation in food, energy and core goods slowed significantly, falling below 2% at annual rates. In contrast, inflation in core services—the largest consumption category—fell but remained well above 2%, thereby preventing headline inflation from returning back to target in 2023.

Although consumption spending declined sharply and across the board during the early months of the pandemic, starting in mid-2020, consumption of goods spiked while consumption of services remained low relative to pre-pandemic levels—because of households’ response to lockdown measures implemented at the time. Consumption on an inflation-adjusted basis returned to its pre-pandemic trend in March 2021, the same month that both headline and core PCE inflation rose above 2%, and it has remained above trend ever since.

Link between Excess Savings and Excess Inflation

The federal government’s response to the pandemic, which included payments to certain individuals and organizations, resulted in a substantial increase in the federal deficit and households’ disposable income. The fiscal assistance explains, in part, why consumption remained persistently elevated through 2023, despite continued above-target inflation and high interest rates. To illustrate the relationship between the rise of disposable income through fiscal policy and high inflation, the figure below shows measures of excesses from the norm in personal savings and inflation. For more in-depth analysis, see Fernando M. Martin’s Oct. 19, 2023, On the Economy blog post “ Is Inflation on the Way Out or Here to Stay? ”

Personal savings are defined as disposable personal income minus personal outlays. The Bureau of Economic Analysis defines personal outlays as the sum of personal consumption expenditures, personal interest payments and personal current transfer payments. Excess personal savings are then computed by subtracting the 2016-19 trend in savings. Accumulated excess personal savings reflect the sum of excess personal savings since January 2016.
Excess inflation is defined as the annual growth rate of the PCE price index excluding energy minus 2%. This measure removes the effect of fluctuations in energy prices, which depend largely on global factors, on inflation but still acknowledges the fact that food prices react to local factors, including government policy, in tandem with other goods and services.

Excess Personal Savings and Excess Inflation Have Steadily Declined

SOURCES: Bureau of Economic Analysis and authors’ calculations.

NOTES: Personal savings are defined as disposable personal income minus personal outlays. Excess personal savings are computed by subtracting the 2016-19 trend in savings. Accumulated excess personal savings are the sum of excess personal savings since January 2016. Excess inflation is defined as the annual growth rate of the PCE price index excluding energy minus 2%.

Excess savings averaged zero until the beginning of COVID-19. Then, because of lower consumption and three rounds of government assistance, there was a significant and persistent increase in personal savings. After peaking at $2.16 trillion in August 2021, accumulated excess personal savings steadily declined. As of December 2023, this excess totaled roughly $300 billion, or about one-fifth of monthly consumption. Even with the dampening effects of higher interest rates, households on average still had the economic means to continue spending above trend and make up for privations related to the pandemic.

Excess inflation followed a similar pattern as accumulated excess savings but with a lag. This co-movement underscores the connection between fiscal policy during the pandemic and resulting inflation. While accumulated excess savings and excess inflation both declined since reaching their peaks, inflation declined a bit faster, likely because of tight monetary policy.

Summary and What’s to Come in the 2023 Annual Report

By the end of 2023, substantial progress had been made toward restoring price stability. However, in his press conference following the December 2023 FOMC meeting , Federal Reserve Chair Jerome Powell commented that “no one is declaring victory” and doing so would be premature. Further, he said, “Restoring price stability is essential to achieve a sustained period of strong labor market conditions that benefit all.”

Economists at the Federal Reserve Bank of St. Louis are actively engaged in research to help us better forecast and understand how inflation arises and how it impacts the labor market and broader economy. The remainder of this annual report essay provides three examples of our economists’ work that relate to inflation. The authors examine these key questions:

How has inflation impacted workers’ wages?
How has the rate at which employed workers move from one job to another affected inflation?
How far into the future can data that are available now be used to improve the accuracy of inflation forecasts?

Impact of Inflation on Workers’ Wages

By Victoria Gregory

In the aftermath of the COVID-19 pandemic, the U.S. sustained some of the highest inflation rates since the 1980s. During the same period, a historically tight labor market led to substantial gains in workers’ wages. For workers, the extent to which their wage growth exceeds inflation—their “real” wage growth rate—says a lot about whether their standard of living is improving from one year to the next. Both components vary from person to person. One individual’s wages may grow in a certain year because of switching to a higher-paying job or getting a raise. Someone else’s employment situation may go in the opposite direction or remain unchanged. People also experience inflation differently because they consume different baskets of goods and services.

To get a complete picture of how all members of the population fared over a certain period, it is important to look beyond the aggregate inflation and wage growth numbers and take into consideration the entire distribution of real wage growth. Recent research has improved the methodology for measuring real wage growth by using existing monthly data. For a less technical summary, see Victoria Gregory and Elisabeth Harding’s Feb. 23, 2023, On the Economy blog post “ Nominal Wage Growth at the Individual Level in 2022 ” and their March 27, 2023, blog post “ Real Wage Growth at the Individual Level in 2022 .” In addition, that particular research analyzed the distribution of real wage growth to see whose wages kept up with inflation and whose wages didn’t during the high-inflation episode in 2021-22. Here, I extend the analysis to 2022-23 as well as 2018-19—before the onset of the COVID-19 pandemic—to establish a pre-pandemic benchmark and study how close we are to returning to that level using the latest available data.

How to Measure Real Wage Growth for Individuals

Measuring real wage growth at the individual level is challenging because there are no datasets that contain a panel of both wages and consumption for a comprehensive set of items. To overcome this, I drew on consumption data from the Consumer Expenditure Surveys (CEX) and wage growth data from the Current Population Survey (CPS) , both from the Bureau of Labor Statistics. The CEX provides information about household expenditures on different categories of goods and services. The CPS contains wage data for individuals measured one year apart, provided that they are employed during the months they are surveyed about wages.

I assigned consumption data to individuals in the CPS using the consumption patterns of individuals in the CEX with similar demographic attributes, including age, education, income and household size. This process resulted in a dataset that combines observed wages with estimated consumption of different item categories. From this, I obtained a measure of each CPS respondent’s annual nominal wage growth and personal inflation rate, which is a weighted average of the inflation rates of the items in the basket of goods and services that the individual purchases. The difference between the two of these is that person’s real wage growth. Real wage gains mean that nominal wage growth exceeded inflation in a given year, while real wage declines mean that inflation exceeded nominal wage growth.

Comparing the Distribution of Real Wage Growth in Recent Periods

The figure below compares the distribution of real wage growth from: 2018 to 2019, which is representative of “normal” years with respect to aggregate wage growth and inflation; 2021 to 2022, the years coinciding with the highest recent wage growth and inflation rates; and 2022 to 2023, which contains the most recent data available and coincides with a cooling of both wage growth and inflation. I organized wage growth into different intervals and, for each year, calculated the percentage of observations in each category.

Real Wage Growth Distribution Shifted to the Negative Range in 2022

SOURCES: Author’s calculations using Consumer Expenditure Surveys, the Current Population Survey and consumer price index data from the Bureau of Labor Statistics.

Before the pandemic, between 2018 and 2019, about 45% of workers experienced a decline in their real wages, much lower than the 54% between 2021 and 2022. Real wage increases were most common in the years before COVID-19. In addition, real wage declines of 5% or larger were least common over this period.

During the peak inflation period of 2021 and 2022, the distribution shifted toward the negative part of its range. Although nominal wage growth tended to be high, the high levels of inflation wiped out these gains for many workers: The median worker saw a 1.5% real wage decline, meaning that half of workers experienced a decline of at least 1.5%. Medium to large real wage cuts also became more common. Since there are always some individuals who have exactly zero nominal wage growth, between 2021 and 2022 those individuals automatically got a much larger real wage cut than normal, typically about 7% to 9%, depending on their inflation rates. As a result, the share of workers with real wage declines between 5% and 15% saw the biggest shift relative to the 2018-19 distribution.

In the following year, the distribution shifted back toward its pre-pandemic range. That is, the proportion of real wage growth in all intervals edged back to levels seen before the pandemic. The median worker had a slight real wage gain, of 0.9%, while about 49% of workers received real wage cuts. However, relative to the period between 2018 and 2019, there were many more individuals with medium-sized wage cuts and not as many with small increases.

After an unusual episode between 2021 and 2022, the real wage growth distribution has started to look more like it did pre-pandemic. However, different groups will likely continue to have distinct experiences in terms of real wage growth. For example, in all three periods considered above, young workers, low earners and people who had switched jobs experienced the highest gains in real wages.

For individuals, their real wages hinge on both the price levels of goods and services they consume and the evolution of their own employment situations. Monetary policy impacts both components. As the Federal Reserve continues to work to achieve price stability, it will be important to consider both components of real wage growth in the coming years to fully understand how the current tightening cycle has impacted the entire population.

Job Switching and Inflation Dynamics

By Serdar Birinci

The Federal Reserve has a dual mandate from Congress of fostering price stability and maximum employment. To determine its policy actions, the Fed monitors inflation and other economic indicators, such as the unemployment rate. The unemployment rate is a relevant measure because it reflects the quantity of employment in the economy—specifically the fraction of the labor force that is jobless.

However, it also is important to understand how well-matched employed individuals are with their existing jobs and employers given their sets of skills. In this regard, there is growing interest in understanding how the quality of employment affects inflation and other macroeconomic outcomes over the business cycle. One such measurement of quality is the rate at which employed workers move from one job to another without an observed unemployment spell in between, known as the employer-to-employer (EE) transition rate or the job switching rate. By examining this indicator, economists can improve their understanding of the relationship between labor market conditions and inflation and, by extension, offer policymakers another possible data point to consider.

Breaking Down Employer-to-Employer Transitions

Why is the job switching rate an important indicator to follow? It can tell us a lot about wage and productivity growth:

Because individuals typically change jobs to make higher salaries, a higher EE transition rate is generally associated with higher wage growth.
Individuals also tend to leave an employer when the new job is a better match for their skills, which allows these workers to be more productive. This movement facilitates a reallocation of workers across jobs, which could contribute to overall productivity growth.

The relative strength of wage and productivity growth over the business cycle affects inflation, and therefore fluctuations in the EE transition rate are relevant for inflation dynamics.

Motivated by these ideas, Fatih Karahan, Yusuf Mercan, Kurt See and I recently co‑authored a paper that investigated how job switching fluctuations affect inflation dynamics. Our analysis was spurred by empirical observations of unemployment and EE transition rates, as well as their impact on employer costs over time. The figure below plots the cyclical components of the unemployment rate and job switching rate. It shows that the correlation between the two series is typically negative. In other words, periods of tightening labor markets, characterized by declining unemployment rates, are typically periods when the EE transition rate rises.

Cyclical Components of Unemployment and Job Switching Rates

SOURCES: Current Population Survey and author’s calculations.

NOTES: The monthly data are from September 1995 to September 2023. Both series are detrended using the Hodrick-Prescott filter with a smoothing parameter of 10 5 . The 12-month centered moving average is used for visual clarity.

However, during the labor market recovery from the Great Recession, in particular during 2016-19, the job switching rate remained flat, despite an approximate 25% decline in the unemployment rate from its trend. This is in contrast to the period from the COVID-19 recession, when the unemployment rate declined by almost the same amount, while the EE transition rate increased by more than 6% from its trend.

Employer-to-Employer Transition Rates and Employer Costs

How did EE transition rates over the past two recovery episodes affect employer costs? To answer this question, my co-authors and I analyzed the time series of unit labor cost (ULC), as shown in the figure below. ULC measures the total compensation paid to a worker for each unit of output produced, adjusted for worker composition and productivity changes over time. This measure is often used by policymakers and researchers to understand labor cost pressures in the economy.

During 2016-19, the average ULC growth was about 2%. However, for almost the same decline in the unemployment rate during the recovery from the COVID-19 recession (from the third quarter of 2021 to the third quarter of 2023), ULC growth reached as high as 6%. Therefore, the different behavior of ULC growth during the two recovery episodes cannot be accounted for by unemployment dynamics alone, but rather can more likely be attributed to differences in EE transition dynamics.

Unit Labor Cost Growth versus Unemployment Rate

SOURCES: Bureau of Labor Statistics and author’s calculations.

NOTES: This figure plots the four-quarter growth rate of the quarterly ULC index (left axis) between the third quarter of 1995 and the third quarter of 2023, as well as the monthly unemployment rate (right axis) between September 1995 and September 2023. For each quarter, we calculate the four-quarter growth rate and for visual clarity use a four-quarter moving average.

Importantly, the 2016-19 episode was characterized as a “missing inflation” episode: Despite a historically low unemployment rate (when one would expect to see wage pressure), annual inflation—as measured by the personal consumption expenditures price index—was about or below 2%.

It appears that a muted EE transition rate, as shown in the first figure, played a role in softening inflationary pressure during this period. In fact, my co-authors and I estimated that muted worker mobility allowed annualized inflation to be about 0.25 percentage points less than it would have been if job switching had increased with the falling unemployment rate during that period.

On the other hand, the 2021-22 recovery period saw something quite different because of a sharp rise in the EE transition rate, as shown in the first figure. In that period, the U.S. economy experienced an elevated number of workers quitting their jobs—a phenomenon some called the “great resignation”—and higher inflation. We estimated that an elevated EE transition rate raised annualized inflation by 0.60 percentage points during that period.

Our findings reveal that, in addition to paying attention to unemployment dynamics, policymakers might want to take into account the rate at which employed workers change jobs. This is because job switching rates in the economy affect employer costs, productivity and, eventually, inflation dynamics.

Inflation Forecasting across Time Horizons

By Michael McCracken

Given its impact on daily life, people put a lot of effort into forecasting inflation. Forward-looking households consider both current and expected future prices in making decisions about when to purchase goods and services. Firms do the same with investment decisions and their own price-setting behavior.

Central to these interactions are the policymaking decisions of the Federal Reserve, which has its dual mandate from Congress to conduct monetary policy to promote maximum sustainable employment and stable prices. The latter part of this mandate is interpreted by the Fed as achieving a rate of inflation that averages 2% over time. Not surprisingly, the Fed invests a great deal of time and energy into forecasting inflation to guide its decisions on monetary policy as it works to promote a healthy economy and financial stability.

How Forecasters Predict Inflation

The steady rise in inflation in 2021 surprised many economists and was initially considered to be transitory. The COVID-19 pandemic and subsequent economic shocks led to previously unseen levels of economic uncertainty that made forecasting inflation particularly difficult. Looking back, one might wonder when forecasters might have expected to be able to predict the rise in inflation.

In the forecasting literature, this time frame is known as the “content horizon.” This concept asks how long into the future can currently available information be used to improve the accuracy of forecasts beyond just using the historical average.

Consider the following baseball analogy: On average, the St. Louis Cardinals are a better team than the Cincinnati Reds, a team they happen to be playing. Absent any other information before the first pitch is thrown, the best forecast is that the Cardinals will defeat the Reds. But once the game starts, information is gathered on the score, injuries, fan support, etc.—all of which affects the best prediction of who will win. In this example, the content horizon is the typical number of innings before the end of the game in which the gathered information is a better predictor of a Cardinals victory than the team’s average record.

In a similar vein, we might gauge the typical number of months into the future that current macroeconomic data can be used to improve inflation forecasts relative to the historical average. As an example, Jörg Breitung and Malte Knüppel found that across a range of countries, including the United States, professional forecasters exhibited a content horizon of two to three quarters when predicting annualized quarterly real gross domestic product growth. See Jörg Breitung and Malte Knüppel’s article “ How Far Can We Forecast? Statistical Tests of the Predictive Content ,” Journal of Applied Econometrics , 2021. In the same exercise, the authors found that when forecasting year-over-year inflation, the content horizon was a bit longer but still only three to four quarters.

In a recent analysis, Trần Khánh Ngân and I revisited their results but in the context of recent U.S. inflation and the Fed’s price stability mandate. For more information, see Michael McCracken and Trần Khánh Ngân’s Feb. 29, 2024, On the Economy blog post “ Core Inflation Revisited: Forecast Accuracy across Horizons .” Specifically, we provided some simple evidence on the content horizon for U.S. inflation across time but relative to the Fed’s 2% target rather than average inflation, per se. The distinction is based on the premise that the Fed acts credibly to achieve its mandate and, over any given forecast horizon, enacts monetary policy that is intended to achieve its 2% target rate of inflation in addition to maximum sustainable employment. This exercise was not intended to illustrate how the Fed constructs inflation forecasts. Instead, it is a simple-to-follow example of the content horizon of inflation forecasts and how that horizon may be limited.

Examining the Accuracy of Inflation Forecasts across Time Horizons

Building on Breitung and Knüppel’s research, for any given month, we forecasted year-over-year inflation three, six, nine, 12, 15, 18, 21 and 24 months into the future. The targeted measure of inflation is the one preferred by the Fed: headline inflation as measured by the personal consumption expenditures (PCE) price index. As a simple-to-use representative forecast, we used year-over-year core PCE inflation—a measure of inflation that excludes food and energy prices, which economists often reference as a measure of “trend” inflation. In other words, we looked at core PCE inflation to see how accurately it predicts future headline PCE inflation. Then, we considered a constant 2% as the benchmark forecast with the idea that the Fed will enact optimal policy to achieve that level of inflation.

The table below shows the average relative accuracy of the two forecasts across all eight horizons during two different time periods: the 14 years prior to 2021 and the following three-year period. Values less than 1 indicate that core PCE is more accurate than the 2% target, while values greater than 1 indicate the reverse. For example, in the years prior to 2021, at the three-month horizon, the value of 0.75 indicates that core PCE inflation was 25% more accurate than the target. (A value between 0.95 and 1.05 indicates no meaningful difference between the two forecasts.)

In broad terms, the results in the table above align with the results found by Breitung and Knüppel. In the pre-2021 period, core PCE inflation was more accurate than the target for horizons three to nine months. At the longer horizons, the gains diminished substantially. In the more recent period, in which there was substantially higher inflation, the pattern continued but was exaggerated. For this period, core PCE was, on average, a more accurate forecast out to 12 months and, perhaps, 15 months. Interestingly, and in contrast to the earlier sample, the content horizon of core PCE not only diminishes but substantially deteriorates at the longer horizons, making the 2% target a more accurate forecast.

As noted earlier in this article, inflation’s rise in 2021 was unexpected and then considered transitory. Based on prior historical experience, it appears that the typical content horizon of headline PCE inflation is about nine months into the future. Beyond that, there doesn’t appear to be much predictive content to work with other than knowing that the Fed will enact monetary policy to achieve its 2% objective. That said, the content horizon lengthened from 2021 through 2023, favoring core PCE at horizons out to 12 months.

A key difference between these two price indexes is that the CPI includes only out-of-pocket expenditures, whereas the PCE price index includes consumption expenditures regardless of how they are paid. (The difference matters for items such as health care.) In addition, housing costs have a significantly larger weight in the CPI than in the PCE price index.
See Milton Friedman’s “ The Counter-Revolution in Monetary Theory ,” Institute of Economic Affairs, 1970.
However, expansions of the money supply in exigent circumstances, such as major wars, have been associated with a rise in inflation. See Kevin L. Kliesen and David C. Wheelock’s “ The COVID-19 Pandemic and Inflation: Lessons from Major U.S. Wars ,” Federal Reserve Bank of St. Louis Review , 2023.
From the mid-1990s through 2019, the Phillips curve was “flat”—that is, inflation was relatively stable, regardless of fluctuations in the unemployment rate. In contrast, since 2022, the Phillips curve has been “vertical,” with a low and stable unemployment rate, despite significant movements in the inflation rate.
For more on these topics, see Fernando M. Martin’s Oct. 19, 2021, On the Economy blog post “ How Widespread Are Price Increases in the U.S.? ” and his Oct. 17, 2022, On the Economy blog post “ Inflation Is Still High and Widespread .”
“Core” explains that the particular category excludes food and energy.
For more in-depth analysis, see Fernando M. Martin’s Oct. 19, 2023, On the Economy blog post “ Is Inflation on the Way Out or Here to Stay? ”
The Bureau of Economic Analysis defines personal outlays as the sum of personal consumption expenditures, personal interest payments and personal current transfer payments.
For a less technical summary, see Victoria Gregory and Elisabeth Harding’s Feb. 23, 2023, On the Economy blog post “ Nominal Wage Growth at the Individual Level in 2022 ” and their March 27, 2023, blog post “ Real Wage Growth at the Individual Level in 2022 .”
See Jörg Breitung and Malte Knüppel’s article “ How Far Can We Forecast? Statistical Tests of the Predictive Content ,” Journal of Applied Econometrics , 2021.
For more information, see Michael McCracken and Trần Khánh Ngân’s Feb. 29, 2024, On the Economy blog post “ Core Inflation Revisited: Forecast Accuracy across Horizons .”
This exercise was not intended to illustrate how the Fed constructs inflation forecasts. Instead, it is a simple-to-follow example of the content horizon of inflation forecasts and how that horizon may be limited.

Fernando M. Martin is an economist and senior economic policy advisor at the Federal Reserve Bank of St. Louis. His research interests include macroeconomics, monetary economics, banking and public finance. He joined the St. Louis Fed in 2011. Read more about his work .

David Wheelock is senior vice president and special policy advisor to the St. Louis Fed president. Also an economist, his research interests include U.S. monetary history and policy as well as the performance and regulation of commercial banks. He joined the St. Louis Fed in 1993. Read more about his work .

Victoria Gregory is an economist at the Federal Reserve Bank of St. Louis. Her research interests include labor economics and macroeconomics. She joined the St. Louis Fed in 2020. Read more about her work .

Serdar Birinci is an economist and economic policy advisor at the Federal Reserve Bank of St. Louis. His areas of research include labor economics and macroeconomics. He joined the St. Louis Fed in 2019. Read more about his work .

Michael W. McCracken is an economist and senior economic policy advisor at the Federal Reserve Bank of St. Louis. His research focuses on econometrics and macroeconomic forecasting. He joined the St. Louis Fed in 2008. Read more about his work .

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Impact of Inflation on Workers’ Wages

Essay on Inflation

Students are often asked to write an essay on Inflation in their schools and colleges. And if you’re also looking for the same, we have created 100-word, 250-word, and 500-word essays on the topic.

Let’s take a look…

100 Words Essay on Inflation

Understanding inflation.

Inflation is when prices of goods and services rise over time. This means you need more money to buy the same things. It’s like a slow-motion robbery!

Causes of Inflation

Inflation is often due to increased production costs or increased demand for goods and services. When people want more of something, and it’s scarce, prices go up.

Impact of Inflation

Inflation affects everyone. If your income doesn’t increase as fast as inflation, you’ll have less buying power. But, if you’re a business owner, you might be able to raise prices and make more money.

Controlling Inflation

Governments try to control inflation by adjusting interest rates, taxes, and government spending. It’s a tricky balancing act to keep inflation low but not too low.

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Paragraph on Inflation

250 Words Essay on Inflation

Inflation, a crucial economic concept, refers to the rate at which the general level of prices for goods and services is rising, subsequently eroding purchasing power. It’s an indicator of the economic health of a nation, with moderate inflation signifying a growing economy.

The Causes of Inflation

Inflation generally occurs due to two primary factors: demand-pull and cost-push inflation. Demand-pull inflation transpires when demand for goods and services surpasses their supply. On the other hand, cost-push inflation arises when the costs of production escalate, causing producers to increase prices to maintain profit margins.

Effects of Inflation

Inflation impacts various aspects of the economy. It erodes the purchasing power of money, causing consumers to spend more for the same goods or services. Inflation can also create uncertainty in the economy, affecting investment and saving decisions. However, moderate inflation can stimulate spending and investment, driving economic growth.

Managing Inflation

Central banks attempt to control inflation through monetary policy. By adjusting interest rates, they influence the level of spending and investment in the economy. Higher interest rates typically reduce spending, curbing inflation. Conversely, lower interest rates stimulate spending, potentially leading to inflation.

Inflation is a complex and multifaceted subject. Understanding its causes, effects, and the measures to control it is essential for both macroeconomic stability and individual financial well-being. As future leaders, it’s crucial for us as students to grasp these concepts to make informed decisions in our professional and personal lives.

500 Words Essay on Inflation

Introduction to inflation.

Inflation is a complex economic phenomenon that affects every aspect of our lives, from the cost of living to the value of money. It is defined as the rate at which the general level of prices for goods and services is rising, subsequently, purchasing power is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.

Inflation is primarily caused by an increase in the money supply that outpaces economic growth. Ever since the end of the gold standard, governments have had the ability to create money at will. If a nation’s money supply grows too rapidly compared to its production of goods and services, prices will increase, leading to inflation.

Additionally, inflation can be spurred by demand-pull conditions, where demand for goods and services exceeds their supply. Cost-push inflation, on the other hand, occurs when the costs of production increase, causing producers to raise prices to maintain their profit margins.

Impacts of Inflation

Inflation affects economies in various ways. While mild inflation is viewed as a sign of a healthy economy, hyperinflation can lead to economic instability. It erodes purchasing power as the same amount of money can buy fewer goods and services. This can lead to uncertainty and a decrease in spending and investment, which can slow economic growth.

Moreover, inflation can harm savers if the inflation rate surpasses the interest rate on their savings. It also favors borrowers, as the real value of their debt diminishes over time. This redistribution of wealth from savers to borrowers can lead to social and economic inequalities.

Central banks use monetary policy to control inflation. They adjust the money supply by setting interest rates and through open market operations. By raising interest rates, central banks can decrease the money supply, making borrowing more expensive and slowing economic activity, thereby reducing inflation.

Furthermore, governments can use fiscal policy to control inflation. This involves changing tax rates and levels of government spending to influence the level of demand in the economy. By reducing demand, governments can put downward pressure on prices and reduce inflation.

Inflation is an intricate part of our economic systems. It is a double-edged sword that can stimulate economic growth when mild, but can also lead to economic instability when it becomes too high. Understanding inflation is crucial for policymakers, investors, and consumers alike as it influences our decisions and shapes our economic reality. By effectively managing inflation, governments can promote economic stability and growth, thereby improving the standard of living for their citizens.

That’s it! I hope the essay helped you.

If you’re looking for more, here are essays on other interesting topics:

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Nice Very Nice

It is helpful …thanks alot

EXCELLENT AND ALSO VERY BENIFICAL FOR US AND ALSO FOR BEGINEERS