This week, Federal Reserve Chair Ben Bernanke made one of his regular trips down the streets of Washington to testify in front on Congress.  The testimony was pretty standard stuff. He talked about the Fed’s efforts to strengthen the economy, the dangers of large banks, and how long they’ll keep stimulating the economy.  One of the things he said was that some of the actions the Fed takes will continue until inflation starts to look like it will hit 2.5%.  This is one of the primary goals of the Fed.  You don’t want inflation too high, or too low.

It’s kind of scary to think the Fed just does all this stuff until inflation rises.  But they aren’t just willy-nilly throwing stuff against the wall until something sticks.  In addition to be the nation’s reserve bank, the Fed is also a large research facility.  They don’t just want to watch inflation, they want to understand it better than anyone else.  Here are three examples of how they’re working to understand inflation in new ways.

Changing commodity prices don’t lead to inflation or deflation: We hear that as oil prices rise, it can increase in the price of just about everything.  Transportation costs go up, food prices go up, everything goes up.  Oil is a commodity good.  And the Fed wanted to understand whether movement in the price of commodity goods impacted overall inflation numbers.  So if corn, ham, copper, and oil all went up, would inflation on everything go up?  Since the 1980s, the answer has actually been no.  This isn’t part of the study, but overall demand for goods is more likely to drive inflation than the prices of commodities.  Commodity prices can be driven by demand, but that isn’t always the case.

When commodity prices go up, business say they pass the cost on to you: Fed researchers conducted a survey of businesses to see how they would react to a price shock of 10% higher prices on the raw materials of what they make.  Not surprisingly, over 50% of respondents said they would pass that cost onto their customers.  But what about if there was a 10% decrease in cost?  Though not quite 50%, the largest number of respondents said they would take that benefit themselves.  In other words, if their prices go up, they make you eat the cost.  If their prices go down, they keep the difference as profit.  This isn’t surprising.  We see this at gas stations.  When prices go up, they raise prices quickly. If they go down, they don’t pass the savings on so fast.

There’s saying and then there’s doing: Businesses might say they pass the cost on to consumers, but prevailing market conditions might not allow for that.  So the last thing Fed researchers looked at was whether these costs are actually passed along to consumers.  Sure enough, they found that increasing commodity prices do actually lead to inflation.  It’s just that decreasing prices don’t lead to deflation, so that on the whole it looks like there isn’t an observable correlation.

Read: Commodity Prices and Inflation: The Perspective of Firms (Federal Reserve Bank of Atlanta)

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categories: banking, economics, government