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The Gap Between Services Inflation and Goods Inflation

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.

Core PCE Inflation and Its Components

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).

Core PCE Inflation and Its Components

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). As a result, the gap between them has historically been positive. The Great Recession saw a reversal of this relationship, when the slowdown in core services inflation and the surge in core goods inflation caused the gap to turn negative in May 2009 for the first time since 1990. The gap once again turned positive in February 2010 and has been widening since. The improving economy helped support services inflation, and from 2011 onwards the rising value of the dollar has weighed on core goods inflation. Recently, with core goods inflation remaining relatively stable, and core services inflation edging slightly lower, the gap between the two has narrowed slightly. Currently it is 2.3 percentage points, which is near its historical average over the past 25 years of 2.8 percentage points. This gap is significantly lower than the peak value of 5.5 percentage points attained in May 2003, which at the time contributed to concerns about the potential for deflation.

Core PCE Goods Breakdown

A number of economists have provided evidence of a close correlation between movements in exchange rates and consumer goods prices, and by extension between exchange rates and the measured gap between services and goods inflation. Given that goods account for the bulk of international trade, movements in exchange rates can potentially exert more pressure on goods prices than on services prices. Generally over time, a strengthening of the dollar (i.e., upward moves in the exchange rate) has tended to be associated with a falloff in goods inflation relative to services inflation, in turn widening the gap, as occurred between 1990 and 2000. Similarly, downward moves in the exchange rate have typically been associated with an acceleration in goods prices, leading to a narrowing of the gap between services and goods inflation, as occurred from 2001 to 2008.

Since 2011 the value of the dollar has been steadily rising and as expected goods inflation has experienced a mild deflation and the gap between the two inflation rates has been widening. However, the sharp appreciation of the dollar over the last three quarters has thus far not appeared to have had a significant impact on core goods inflation or on the gap. This may be because the historical correlation observed between the exchange rate and the services-goods gap of 0.55 requires some time to manifest fully. If so, then the impact of the recent sharp appreciation of the dollar on core goods inflation and the increasing gap between services and goods inflation may show up in the next few months.

Core PCE Goods Breakdown

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