Academic journal article Economic Review - Federal Reserve Bank of Kansas City

An Evaluation of the Decline in Goods Inflation

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

An Evaluation of the Decline in Goods Inflation

Article excerpt

Over the past decade, inflation around the globe has dropped-so much that the worldwide average has plummeted from 30 percent to 4 percent (Rogoff). For many countries, especially those starting out with high inflation rates, falling inflation has been desirable. But the experiences of other countries have raised the question of whether inflation can be too low. In some economies, inflation has dipped to levels that risk disruption of the normal functioning of the economy. At the extreme, Japan and Hong Kong have experienced deflation-a sustained decline in the aggregate price level, reflected in negative inflation rates. In countries such as the United States, goods prices have been falling, even though services prices continue to rise at a healthy pace, keeping overall inflation positive.

Many commentaries on the potential for deflation in the United States have noted the sharp contrast between goods and services prices. Excluding food and energy, goods prices as measured by the chain price index for personal consumption expenditures (PCE) dropped 2 ¼ percent in 2003. Yet nonenergy services prices rose nearly 2 ½ percent last year. Moreover, goods inflation has fallen sharply over the past decade or so, while services inflation has declined only modestly. In 1993, PCE inflation was about ¾ percent for goods and 3 ¾ percent for services.

This article assesses whether the decline in consumer goods inflation relative to services should be cause for concern in the United States. The analysis focuses on three interrelated questions about the decline in goods inflation relative to services: Was it unusual; what caused it; and is it likely to continue? The first section examines the extent to which the recent U.S. experience is unusual by historical and international standards. The potential explanations evaluated in the second section include: a deterioration in the accuracy of measured services inflation, an increase in productivity growth for the goods sector compared to services, rising demand for services relative to goods, and downward pressures on goods prices due to the rising value of the dollar or height-ened global competition. The third section assesses whether the falloff in goods inflation relative to services is likely to persist. The article concludes that, at present, there is little cause for concern in the United States. The fall in goods inflation relative to services over the past decade is most likely a temporary phenomenon due to dollar appreciation and, to a lesser extent, increased global competition.

I. U.S. HISTORICAL AND INTERNATIONAL EVIDENCE

Economists have long known that goods inflation is normally well below services inflation. In such historical context, the falloff in goods inflation relative to services over the past decade may not be unusual for the United States. Similarly, the recent U.S. experience may have been shared by other industrialized economies. After first reviewing the inflation measures used in the analysis, this section examines historical movements in U.S. goods inflation relative to services and more recent international evidence on the behavior of consumer goods and services inflation.1

Taken together, the historical U.S. and recent international evidence reveal the past decade's decline in core goods inflation relative to services to be somewhat unusual and perhaps temporary. In the United States, the differential between goods and services inflation has widened fairly persistently over the past decade, reaching record or near-record levels, depending on the measure of inflation. Some other industrialized countries, such as the United Kingdom and Canada, also experienced a significant falloff in goods inflation relative to services. In these foreign economies, however, goods inflation relative to services reversed course and rose in the last few years. Moreover, in Europe and Japan, goods inflation actually increased relative to services in all or part of the 1990s. …

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