Inflation Outlook for 2011

May 3rd, 2011 | By | Category: Lead Story

There have been a number of articles written recently on the subject of inflation.  Given the extraordinary measures undertaken by the Federal Reserve over the past few years (QE, for example) as well as the recent run-up in food and commodity prices, many fear a return to above-average levels of inflation.

What many fail to consider however is that inflation is not sustainable without an accompanying increase in personal income.  In this article we will consider the historical relationship between Disposable Personal Income (DPI) and the Consumer Price Index (CPI).

Inflation Is Not Always Bad

In fact, a small amount of inflation is healthy.  Deflation–or when the prices of goods and services decrease–is a very unhealthy condition for a country.  Please read this article for a more in-depth review of the effects of deflation.  Different countries set different ranges for so-called healthy inflation.  Developed countries typically set lower rates than developing countries (for example, the U.K. has a much lower rate than China).  In the U.S., the target rate of inflation (for Personal Consumption Expenditures, or PCE) is 1.5% to 2.0%. 

DPI Drives Inflation

As revealed in the recent FOMC press release (April 27, 2011), the Federal Reserve believes that the run-up in food and energy costs are transitory.  To fully understand why consider how the market is constantly adapting–finding equilibrium between supply and demand.  There is a time lag as suppliers and consumers adjust and so the market is typically out of equilibrium, but working towards it.

If the price of goods and services increase at a rate faster than the increase in personal income demand will drop as people scale back or find alternatives.  As the demand curve shifts and finds the new equilibrium and price will eventually fall. 

Inflation can simply not continue to increase at a rate greater than the increase in personal income. 

The graphic below illustrates the relationship between DPI and inflation (as measured by the CPI).  The light tan line represents the percentage increase in DPI year-over-year (for example, the percentage increase from March of 2010 to March of 2011).

The relationship is clear.  Over the past forty years there has only been a few times when CPI was higher than DPI growth.  It appears as though DPI acts as a ceiling of sorts.

Looking Forward

Looking at the data from the past several quarters we can see that both DPI and the CPI are increasing back into the safe target zone.  Until DPI growth returns to a higher range (above 4%), CPI is unlikely to increase significantly above the Fed's target of 2%. 

Click here to download the Excel worksheet with the DPI and CPI data referenced above.

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