Consumers listening to inflation comments from the Federal Reserve must be scratching their heads. Ben Bernanke, the head of the Federal Reserve, continually tells us inflation is either subdued or transitory.
In other words, prices are not rising much and those that are will eventually come back down. This flies in the face of what just about everyone else sees in the grocery store and gas pump so what exactly is the Federal Reserve looking at.
If you listen carefully to the press releases, you will hear the word “inflation expectations” instead of just the word “inflation.” Inflation expectations are what the Federal Reserve is more concerned about and it is indeed different then inflation.
Pure economic definitions aside, most people know inflation as rising prices in goods and services and indeed they have been rising quite alarmingly as of late. But although the Feds do look at a general rise in prices for guiding their economic policy,
they focus more on what people expect prices to do. Hence the more enhanced definition “inflation expectations.”
In plain language, “inflation expectations” are how people feel and perceive price increases and whether they will continue and even get worse. The theory is that if you see a rise in price and think the price will be even higher tomorrow, it might spur you to buy the item today in fear of paying more tomorrow. This “expectation” of an even higher price tomorrow permeates into society as a whole. The feared result is that more and more people start rushing out to buy things regardless of whether they need them today or not. Now they just start buying to avoid the higher price tomorrow. In essence, consumers start hoarding or stockpiling goods to avoid the higher prices they expect are coming. This is a change in the normal buying patterns of consumers and accelerates the amount money changing hands. Economists call this accelerated buying pattern “money velocity.”
This new pattern of consumers now buying today to save themselves from higher prices tomorrow actually increases demand today as people buy more then they normally would. Money now changes hands more rapidly (money velocity increases) and subsequently increases demand even faster.
This increased demand now drives prices up even more which further reinforces consumers fear of higher prices. Then they buy even more.
The cycle of higher prices causing more demand causing even higher prices puts the economy and the money supply on steroids. As more money changes hands more rapidly, a viscous price spiral upwards takes place.
It’s this pattern the Feds fear more then just rising prices. An occasional price rise in certain goods usually won’t lead consumers into this panic behavior buying but ongoing and consistent across the board price increases can.
For now, the price rises we have seen at the store haven’t panicked the herd yet, but the Feds should be very careful here. For inflation, much like a stampede, once it starts, can be difficult to stop.