NEW YORK (TheStreet) -- Inflation is one of the most important factors considered when the Federal Reserve decides whether or not to change interest rates. Understanding the importance of inflation helps one understand why the Fed does what it does and why it keeps a keen watch on a very low or a very high inflation rate.
Inflation control is considered "a crucial responsibility" by Fed chief Janet Yellen, who highlighted it in a 52-minute presentation at the University of Massachusetts at Amherst on September 24. "Inflation control is one half of the dual mandate that Congress has laid down for the Federal Reserve, which is to pursue maximum employment and stable prices," she said.
With that in mind, here are five things everyone needs to know about inflation.
1. What is inflation and who controls it?
Inflation happens when the average prices for goods and services go up over a period of time. It reduces the purchasing power of one dollar, which means a loss of the real value of money. When inflation happens, your money becomes less valuable.
Inflation is indirectly controlled through monetary policies under the Federal Reserve. When inflation is too high, the Fed may consider the economy "too hot" and may raise interest rates to slow it down. When inflation is too low, the Fed may lower interest rates in an attempt to spur growth. But the Fed needs to be careful: Controlling inflation through wages and price control can lead to recession, adversely affecting those who lose their jobs because of it.
Inflation is closely watched by many central bankers across the world, and how much inflation is tolerated before interest rates are changed varies from year-to-year and from currency-to-currency. Advanced and emerging nations work under different inflation rates. Very high inflation or negative inflation (known as deflation) is a signal that the economy has a problem and needs to adjust.
2. How well does the central bank do in attempting to control inflation?
The Fed tries its best to keep inflation under control and, according to Yellen, it is not always successful in fulfilling the "price stability element." A figure highlighted during the Fed chief's speech shows that the Fed had in the past deviated from its original goal on some occasions. The U.S. has experienced subdued inflation since the end of recession in 2009, appreciably below the Federal Open Market Committee's 2% objective.
3. Which index does the Fed consider when analyzing inflation?
The Fed looks at different inflation rates, but it adopted personal consumption expenditure price index as its official target, which excludes food and energy indicators. The central bank frequently emphasizes on "the price inflation measure for personal consumption expenditures (PCE), produced by the Department of Commerce, largely because the PCE index covers a wide range of household spending." Because the consumer price index (CPI) reflects a strong influence from energy prices and tends to show stronger fluctuations in comparison to the PCE, the Fed gives more emphasis to the latter, which is less volatile.
According to the central bank, "Various indexes can send diverse signals about inflation," and hence it monitors several different price indexes in order to capture prices of various products and services. However, since food and energy also form a considerable portion of household budgets, the Fed's inflation objective is outlined in terms of the "overall change in consumer prices." The Fed policymakers observe a range of "core" inflation measures to help identify inflation trends.
4. What is the Fed Target Inflation Rate?
The Fed tries to maintain a moderate inflation depending on the economic situation of the country. It has set an inflation target to manage the public's expectation of inflation. The target inflation helps the Fed in deciding when the economy could moderately be reflecting an ideal inflation rate (that is, 2%). The central bank will raise or lower interest rates based on above-target or below-target inflation, respectively. The FOMC adopted the target inflation rate of 2% as measured by the PCE price index. The European Central Bank and the Bank of England also have 2% as their inflation targets.
The FOMC tries to achieve the 2% target over the medium term by implementing monetary policy. Since the recession ended in 2009, the U.S. has experienced inflation running appreciably below the FOMC's 2% objective, in part reflecting the gradual pace of the economic recovery.
5. What causes inflation?
Here are two ways inflation can happen:
1. Demand-Pull Inflation: Aggregate demand for goods and services increases and it exceeds supply. Maintaining the prices at the same level will result in s sellout. Hence, suppliers resort to the luxury of raising prices that results in inflation. Discretionary fiscal policies, marketing and new technology growing economy and expectation of inflation can lead to demand-pull inflation.
2. Cost -Push Inflation: Cost- push inflation is less common than demand-pull inflation. It results from shortage of supply and enough demand for suppliers to raise prices. Wage inflation can lead to such a situation to occur. Other factors could be government regulation and taxation, fall in currency exchange rates creating cost-push inflation in imports.
Expectations can also play a role.
"Theory suggests that inflation expectations, which presumably are linked to the central bank's inflation goal, should play an important role in actual price setting," Yellen said in her speech. Clearly, the existence of "well-anchored inflation expectations" can help the Fed in achieving both of its objectives-- price stability and full employment.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.