Falling inflation in the US

The US economy is currently experiencing a period of disinflation. June’s rate of inflation in the US has fallen to 3% and the country might be seeing the end of the work inflationary period for over 40 years. The latest CPI data is evidence that the contractionary monetary policy used by the Federal Reserve (US Central Bank) has been successful in bringing inflation down from its peak in June 2022 of 9.1%.

The chart shows how US base interest rates have changed over the last 12 months, increasing​​​​​​​ from 0.25% to 5.5% and how inflation has fallen from 8.5% to 3%. The interest rate and inflation rate relationship is one that macroeconomic theory predicts. As interest rates rise in the US consumption and investment are both expected to fall as borrowing costs increase and so does the reward for keeping funds in the bank. As consumption and investment fall this reduces US aggregate demand, and this leads to a fall in the country’s rate of inflation. A rise in US base rates can also lead to an increase in the value of the US dollar which decreases US import prices and this puts downward pressure on inflation.

​​​​But contractionary monetary policy does not fully account for the fall in US inflation. As the world economy has continued to recover from the supply chain constraints the cost of manufactured goods such as cars and computers has decreased. The decrease in energy costs has been a very significant factor in the decline in US inflation because of its high weighting in the CPI. Oil and gas prices which are so important for US households in terms of travel costs and heating their homes have declined sharply. In addition, falling energy prices decrease US business costs and this filters through to consumer prices.

Despite the relatively good news on the fall in the US CPI, there are still some concerns about the core rate of inflation which increased by 0.2% in June to 4.8%. The core rate of inflation excludes goods which have more volatile prices such as energy and food. Because of this, some economists in the US are arguing for a further increase in US base rates.

Possible points to discuss with a class

1. What is disinflation?

2. Why has the US central bank increased interest rates?

3. How does increasing interest rates reduce inflation?

4. Apart from interest rates, what other factors has reduced US inflation?

5. What is core inflation?