Magazine article Economic Trends

The Gap between Services Inflation and Goods Inflation

Magazine article Economic Trends

The Gap between Services Inflation and Goods Inflation

Article excerpt

Inflation as measured by the price index for personal consumption expenditures (PCE) has been running below the Federal Reserve's longer-run objective of 2 percent for the last three years. Similarly, the PCE price index excluding food and energy, also known as core PCE inflation, has been below 2 percent over the same period. Core PCE inflation as of April 2015 was 1.24 percent on a year-over-year basis. This reading is little changed from where it was in early 2014 in spite of improvements seen in the labor market over the last year, as pass-through from sharply lower oil prices and a sharply stronger dollar have weighed on inflation readings.

Digging a little deeper into the behavior of the two components of core PCE inflation, core services and core goods, may provide some additional insights into why core inflation has been coming in persistently low and whether there is a cause for concern that it could remain low going forward. Doing so reveals that subdued core services inflation continues to be the primary factor keeping core inflation low.

Since the early 1990s, inflation rates for both core services and core goods inflation have declined sharply, with core goods inflation falling more than core services inflation. While core services inflation never fell below 2 percent, core goods inflation continued to decline and eventually became negative by the mid-1990s. Since then, it has been consistently and significantly negative. Core services inflation has gradually trended up from its recession lows and stabilized around 2 percent over the last three years. Currently it remains near that level, a full percentage point lower than its average in the five years prior to the Great Recession.

One can glean additional insight into the deflationary behavior of core goods inflation by looking at the behavior of its two subcomponents: durable goods and nondurable goods (both of which exclude energy and food). It is durable goods which have had the greatest effect on total core goods inflation. Since 1995, durable goods inflation has been persistently and significantly negative. It measured -2.2 percent in April 2015 on a year-over-year basis, whereas nondurable goods inflation was 1.2 percent.

The large spikes observed in total core goods inflation around the Great Recession and one year later were primarily driven by spikes in nondurable goods inflation. A little digging reveals that those spikes were indeed driven by temporary factors. The spike in 2009 was due to an increase in tobacco taxes introduced that year, which at the time was dubbed one of the largest federal tax increases in US history. Another spike in nondurables occurred around 2011-2012 and was partly due to a sharp rebound in clothing prices, which had been falling for more than a decade.

Over the last two years, the inflation rates for nondurable goods and durable goods have been on a divergent path, with durable goods inflation trending lower and nondurable goods inflation trending higher. The combined effect has kept overall core goods inflation relatively stable (but negative).

Past studies (see Peach, Rich, and Antoniadas 2004, and Peach, Rich, and Linder 2013) have stressed the importance of examining the underlying behavior of these two major components of aggregate inflation along with the measured gap between them, because such information may provide deeper insights into the observed behavior of aggregate inflation and help to inform the near-term outlook for aggregate inflation

It has been well documented that core goods inflation is usually lower than core services inflation (see Clark 2004). …

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