Bohanon & Curott: Consumer price index changes justify inflation concerns

The Bureau of Labor Statistics reported the April Consumer Price Index rose 4.2% on a year-to-year basis. How concerned should we be? The CPI measures the price of a basket of goods and services consumed by the “typical” American household. The basket is indexed to a value of 100 in its base year. Inflation is sustained increase in the CPIi over an extended time frame. This is in contrast with a one-time increase in the CPI.

Suppose we live in a zero-inflation economy where the CPI has been at 100 for decades. An investor buys a government bond for $100,000 and is promised $115,927 in five years. That computes to a 3% real interest rate on the bond, assuming that the CPI remains at 100.

Now let’s say the CPI rises by 3% per year every year for five years. At the end of year five, the CPI is 115.927 indicating that prices are on average 15.927% higher than in year zero.

Contrast that scenario with the following: The CPI stays at 100 in years 1 and 2, jumps to 115.927 in year 3, and then remains at 115.927 in years 4 and 5.

The former scenario is inflation, the latter is a one-time increase in prices.

At first glance this may appear to be a distinction without a difference. The typical basket of goods and services is 15.927% more expensive in year 5 in both cases. The investor ends with a real return of zero as the increase in the price level erases all her gains.

However, under the inflation scenario investors will likely expect a 3% rise in the CPI in the future, and these expectations will get “baked into” nominal interest rates. Five-year government bonds will have a 6% nominal rate. That’s not so much the case in the second scenario. If the CPI rise is perceived as a one-time event, nominal interest rates most likely stay at 3%.

So what about last week’s news? The Treasury and the Federal Reserve are spinning the story that the CPI spike was more a by-product of unique COVID related realities than an underlying indication of a rising rate of inflation.

We hope they are right, but given the enormous expansion of the monetary base and the Fed’s apparent iron-clad commitment to an easy money policy, we think we are justified in raising our level of inflation concern from yellow to orange!•

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Bohanon and Curott are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.

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