Global Factors and Domestic Inflation
US inflation moved up this spring after subdued readings in late 2013 and at the start of 2014. Measured on a year-over-year basis, inflation was stable near 1.6 percent from April through July according to the price index for personal consumption expenditures (PCE). As is normally the case, inflation measured by the consumer price index (CPI) was somewhat higher, averaging 2 percent during that time, though it too was relatively stable.
The August CPI report broke this stable trend. The CPI declined 0.2 percent on the month, pulling the year-over-year CPI inflation rate down to 1.7 percent. While food inflation slowed during the month and gasoline prices fell, the bigger surprise was in the core CPI measure, which excludes food and energy prices. The core CPI was essentially unchanged in August, its weakest monthly reading since January 2010, which pulled the year-over-year core CPI inflation rate down to 1.7 percent as well. The Cleveland Fed’s median CPI tends to be more stable than either CPI or core CPI inflation, but it also edged lower in August.
Inflation is clearly volatile from one month to the next, so it is not necessarily a good idea to put too much weight onto a single month’s readings. And the Federal Open Market Committee, in its most recent Summary of Economic Projections, continues to expect that inflation will gradually rise over the next few years. But the persistently low inflation rates through much of the last year and a half suggest that inflation continues to be weighed down by a variety of forces, even as the recovery in the US economy progresses.
One potential factor that could be weighing on domestic inflation—and which might serve as a headwind to future increases in inflation—is recent international developments. For example, the economic recovery in the euro zone has been unsteady. Growth stalled in the second quarter, and year-over-year inflation through August came in at 0.4 percent, well below the European Central Bank’s (ECB) objective. As a result of these developments and a worsening medium-term inflation outlook (including declines in measures of inflation expectations), the ECB recently implemented a more accommodative monetary policy. In addition, Japan’s economy is working through the effects of a 3 percentage point increase in the value-added tax rate in April.
How might international developments such as these affect US domestic inflation? One potential channel is through lower import price inflation. A stronger US economy relative to other economies may result in a stronger dollar, which could make imports less expensive and put downward pressure on US inflation. Faced with weak demand at home, foreign companies may decide to reduce the prices of goods they sell to the US. The prices of commodities traded on global exchanges—many of which are priced in dollars—could also soften. The dollar has generally been strengthening since the European debt crisis first erupted in 2011, and it is up sharply over the last few months. The financial press has described the potential for further strengthening in the dollar if monetary policies diverge between the US and foreign economies.
While there is some evidence to support this pass-through channel, it is generally not very strong. The first requirement for such a channel is a link between the dollar and import prices, and this link does seem to exist. Since 1990, increases in the dollar have tended to coincide with declines in nonpetroleum import prices; the correlation is about −0.5. The relationship has been about the same over the last five years or so. So a strengthening dollar could be a force weighing on import prices.
The second part of the equation is whether those declines in import prices pass through to the prices that consumers actually pay. We would expect to see a bigger impact from import prices on goods prices than services prices, because goods may have more imported content or be subject to more intense international competition. Since 1990, it has been the case that declines in nonpetroleum import prices have coincided with declines in core goods prices, but the relationship is weak—the correlation is only 0.2. In fact, over the last five years, the two series have shown little common movement.
While pass-through channels may not be very strong, is it possible that global inflation trends may still provide some useful signal for the US? Perhaps surprisingly, the answer appears to be “yes.” Our inflation conference earlier this year featured a paper suggesting that global inflation is a useful predictor of US inflation, despite weak measurable pass-through. Since 1984, the global inflation trend has actually done a bit better at predicting one-year-ahead inflation than the long-run inflation forecast from the Survey of Professional Forecasters (SPF), which is a typical measure of trend inflation. Since early 2013, this global inflation measure—mapped into US PCE inflation—has been running at only about a 1.5 percent level, a rather prescient forecast! To the extent that this global inflation trend continues to be a useful predictor of future domestic inflation, its ongoing low readings compared with the SPF’s long-run forecasts of 2 percent point to the potential for additional subdued US inflation ahead.