By Perc Pineda, Ph.D.

Chief Economist


There is a barking dog in the economy and its name is inflation. Headline inflation in June, measured by the Consumer Price Index (CPI), came in at 5.4% from a year earlier. Core inflation, which excludes volatile food and energy prices, was 4.5% in June. While energy commodities and used car prices magnified the increase in prices last month, the business and household sectors of the economy have had to deal with rising prices since March. Following 2.6% inflation in March, April and May continued to see inflation at 4.2% and 4.9%, respectively.

The U.S. economy recovered quicker than expected from the slowdown last year. The strong demand for goods caused inventory to decrease. This occurred because the services sector of the economy was still under pandemic restrictions. Businesses generally welcome falling inventory due to brisk sales if they can restock or replenish their inventory. Unfortunately, the aggregate supply side of the economy has not recovered as fast as aggregate demand. The COVID-19 restrictions have caused shortages of materials and labor leading to production and lower capacity utilization.

Policy explanation to inflation

Lower production is one side of the inflation story. The other side is liquidity. U.S. expansionary monetary policy was in high gear with the injection of liquidity into the financial markets and near-zero interest rates as the economy went into lockdowns last year. It was the appropriate monetary policy response at that time. Government stimulus was also the appropriate fiscal policy response to protect the balance sheets of businesses and households.

Interest rates remain low, and liquidity still runs high today—more than a year after the COVID-19 lockdowns. Hence, demand continues to increase against the backdrop of slow-rising production. The economy needs a boost of productivity through human capital. The U.S. employment-population ratio needs to increase, which may happen after the extended unemployment benefits expire in September. Currently, the economy's business sector continues to deal with materials and labor constraints alongside households with money to spend.

Some prices change infrequently

Prices are expected to rise when the economy continues to expand. Monthly data, in particular, are noisy. But higher inflation due to significant increases in some items, such as energy commodities (44.2%) and used cars and trucks (45.2%) in June is consistent with the Federal Reserve's view that the inflation is transitory.

A study by Bils and Klenow (2004) showed that some prices in the CPI change more frequently than others.[i]  The Sticky Price Consumer Price Index, less food and energy, captures the price changes in some categories that change infrequently. Data from the Federal Reserve Bank of Atlanta shows that this index was up 2.6% in May year-on-year. In June, it stayed at 2.6%, lower than the 4.5% core inflation.

What's ahead?

One view is that until we see a catch-up in production, the "transitory" inflation could stick around. Another view is we could be approaching the peak of price increases and will start to moderate.

More balanced consumption of goods and services could temper the increase in prices. For instance, lumber prices dropped 40.0% in June. Industry observers note the decrease was due to softening demand. Consumer behavior is changing. Households are switching from renovation and building projects to trips and vacations as the services sector of the economy reopens.

Market signals of higher commodity production would generate pricing speculation. On July 15th, oil prices fell as investors prepared for an increase in oil supply following a recent production compromise between key OPEC producers. Commodity markets are global and shifts in production affect all countries.

On the policy side, raising interest rates would be “pushing on a string,” or ineffective, considering that the economy is not at full employment. However, a slowdown of the Fed’s asset purchases could happen this year or early next year—a view expressed by the San Francisco Federal Reserve’s President.[ii] Still, the latest testimony of the Federal Reserve Board’s Chairman Jerome Powell to Congress points to expansionary monetary policy in the near term.

We live in a global economy and rising inflation is not unique to the U.S. economy. Moreover, external factors are contributing to rising prices such as the recent surge in container freight rates. The U.S. is the world’s top importing country. In the first quarter, merchandise imports were 16.3% of gross domestic product (GDP)—or 23.2% of personal consumption expenditures. Supply chain difficulties in other countries—particularly major U.S. trading partners—affect the U.S. economy.

What does this all mean? Stay tuned. The world is still recovering from the pandemic. Prices will continue to adjust in response to market realities.  However, rising inflation could cause global economic growth to slow.



[i] Mark Bils & Peter J. Klenow, 2004. "Some Evidence on the Importance of Sticky Prices," Journal of Political Economy, University of Chicago Press, vol. 112(5), pages 947-985, October.

[ii] Jeff Cox, 2021. “Fed’s May Daly says tapering of bond purchases may start this year,” CNBC, July 13, 2021.