Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Historical and Recent Behavior of Goods and Services Inflation

Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Historical and Recent Behavior of Goods and Services Inflation

Article excerpt

* Since the late 1990s, the gap between the inflation rates of services and goods has expanded to a record level as services inflation has remained relatively high while goods prices have actually been falling.

* The widening gap has led some observers to conclude that continued rapid increases in services prices will spell faster overall inflation, while others argue that the progressively steeper decline of goods prices will result in deflation.

* A study of the 1967-2002 period finds that the gap between inflation rates has a strong tendency to return to a "constant equilibrium value" in the long run.

* When the gap is above its long-run value, as it currently is, a rise in goods inflation and a decrease in services inflation should combine to restore equilibrium.

1. Introduction

An interesting and often noted feature of the current inflation experience has been the growing divergence between the rate of increase of services prices and that of goods prices. For decades, prices of services have tended to increase faster than prices of goods. But since the late 1990s, the "gap" between these two inflation rates has widened to a record level and become quite persistent as services inflation has remained relatively high while goods prices have actually been declining.

The expanding gap between goods and services inflation has led to differing opinions--many of them pessimistic--about the near-term outlook for overall inflation in the United States. Some commentators, for example, argue that the continued rapid increases in services prices will bring about faster overall inflation. Others are convinced that the progressively steeper decline of goods prices will lead to a falling overall price level, or deflation.

In this article, we model the relationship between goods inflation and services inflation from 1967:2 to 2002:4. To help inform the inflation debate, we then use our results to forecast inflation for 2003. The specific inflation series that we model is the quarterly change (at an annual rate) of the core personal consumption expenditures (PCE) deflator, or the PCE deflator excluding its food and energy components. (1)

We find that over the past thirty-five years, core PCE goods inflation and core PCE services inflation have experienced permanent increases and reductions, but these shifts have moved roughly in tandem. (2) That is, the difference, or "gap," between the two inflation rates exhibits a strong tendency to revert back to a constant equilibrium value in the long run, a process known as mean reversion. In the short run, however, the gap displays cyclical fluctuations, tending to widen around business cycle peaks and narrow during recessions and the early stages of recovery. When the gap is above its long-run value, as it currently is, equilibrium is restored through an increase in core goods inflation and a decline in core services inflation.

These findings provide the basis for our estimation of a vector error-correction model (VECM) to forecast overall core PCE deflator inflation for 2003. The VECM is a particularly attractive model because it admits an explicit role for the gap and thereby offers a convenient framework to analyze the gap's behavior over time. This model, which assumes that the gap will revert to its long-run value in the same manner it has in the past, points to a fairly stable level of core PCE deflator inflation. Thus, we conclude that the pessimistic outcomes suggested by the current inflation debate are not likely to occur in the near future. In another result, we find that the VECM approach to forecasting core PCE deflator inflation over a one-year horizon is somewhat more accurate than a popular alternative, the random-walk model.

Our analysis proceeds as follows. We begin by providing some background on the core goods and core services price indexes used in this study and investigate their time-series properties. …

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