A Tale of Two Inflations

For some time now, the disparity between price increases for imported goods and price increases for domestic goods and services has been of great interest to me and, after working through all of the applicable Labor Department data on this subject, it quickly becomes clear that there is an interesting story to tell here about two very different types of U.S. inflation in recent years - domestic inflation and imported inflation.
The data in the graphic above will be detailed in the paragraphs ahead because it is deserving of close inspection. To be sure, it is a quite fascinating subject for those not familiar with how dramatically inflation in the U.S. has changed over the years.

But, the more important point to be made here first is that this disparity between domestic and imported inflation was one of the primary reasons why central bank policy in the U.S. had been steering us on a wayward course for so many years. Clearly, two of the major factors that enabled the nation's "easy money" policies for the past two decades have been:

1. The fixation on consumer prices (while ignoring asset prices)
2. The irrational fear of falling prices (today and in 2002-2003)

To a large extent, the Holy Grail of benign inflation and the threat of deflation were not what they appeared to be. In short, the deceptive combination of sharply rising domestic prices combined with falling prices for imported goods has been a major contributor to policy mistakes by the central bank, one of many policy mistakes made over the years that have now come home to roost.

Breaking the Consumer Price Index Apart

The Labor Department breaks consumer prices down into eight major categories, weighted as shown below. This composition is intended to represent a "basket of goods" that consumers purchase and the overall, weighted increases in prices are intended to represent the "rate of inflation" in the U.S.
For the purposes of this discussion and as the source for all the charts that appear here, only original Labor Department data is used and all issues related to such things as hedonic adjustments, geometric weighting, and other factors that contribute to the "reported" rate of inflation almost always coming in lower than the rate of inflation experienced in the "real" world will be ignored.

Importantly, lower "reported" inflation goes a long way in limiting government liabilities for such things as cost of living adjustments and makes central bankers, the stewards of American fiat money, look better than they otherwise might, so, this is not a subject that should be dismissed as inconsequential because, clearly, it is not.

It just won't be part of this discussion.

As for separating the consumer price index (CPI) into "domestic" and "imported" components, in looking at the top-level categories above, one can clearly spot a few that are predominantly domestic - education/communication, food/beverages, and medical care - and, while there are surely some imported goods in each of these groups (e.g., the 0.214 percent weighting for personal computers within the first group), it can safely be said that the "domestic" label fits all three.

Similarly, since the U.S. essentially stopped making their own clothes years ago, it can safely be said that the apparel category consists of primarily imported goods.

But, after that, things get a little trickier.

Making Sense of the Housing and Other Categories

The housing category breaks down as shown below and, as noted here many times before, probably the single biggest blunder of all regarding the consumer price index was the substitution of "owners' equivalent rent" for the cost of homeownership back in 1983.
As far as monetary policy is concerned, this was one of the major "enablers" for the late great housing bubble and its subsequent bursting since there would have been little chance of short-term lending rates resting at one percent back in 2003 and 2004 if home prices that were rising at an annual the rate of eight to ten percent nationally had been included in the calculation of consumer prices rather than the dubious measure of what homeowners think their place might rent for.

In fact, owners' equivalent rent has so distorted consumer prices in the U.S. that they, along with rental costs within the "Shelter" subcategory of the CPI, are completely excluded from the domestic/imported inflation discussion here.

[Note: For a complete breakdown of the CPI categories see this item at the BLS.]

With rents excluded from this list you are left with one sub-category of goods that is mostly imported - household furnishings - and the rest can be safely categorized as domestic.

Moving on to the transportation category we find cars, trucks, and the fuel that is required to run them and, while these are clearly both domestic and imported goods, the task of separating the two is nearly impossible. Since they are primarily made in the U.S., for the purposes of this discussion they are considered domestic.

Similarly, the recreation and other goods and services categories contain a mix of products, however, here they can be easily segregated. For example, nearly all cameras and audio equipment are imported while movie tickets and film processing are domestic services. And in the final "other"category, tobacco products are clearly home grown while personal care products are largely imported.

Prices for Imported Goods Are Falling Faster Than You Think

Lo and behold, when only looking at products that are imported (mostly from Asia), one sees that we've had "deflation" for quite a few years now and not just the "one-off" variety where readings come in at minus one percent and persist for only a month at a time.

For example, the apparel category has posted year-over-year price declines in 13 of the last 14 years and clothes cost a cumulative 15 percent less than they did in the 1990s.
Now that's what I call "deflation", though, it has more to do with cheap labor and fixed exchanged rates in Asia than it does with anything else.

Prices for most imported goods have been declining consistently over the last decade, however, you don't hear too much about this as most news reports and analysts cite the headline inflation numbers or, worse, "core" inflation, excluding food and energy.

Falling prices for imported goods have been a key factor in being able to report overall "moderate" rates of inflation in recent years.

Prices for Domestic Goods and Services Are Quite High

On the domestic side, when looking past the volatility that somewhat obscures the underlying pattern in the chart below, prices are clearly rising much faster than headline inflation has been indicating, particularly since the turn of the century.

[Note: The scales are the same for the chart below and the one in the previous section in order that the magnitudes can be more easily compared.]
While food price have been rising only modestly up until last year, it probably won't come as a surprise to anyone to learn that medical services costs have more than doubled over the same period of time that apparel prices have plunged, as noted in the previous section.

It is not until you look closely at the individual components of the consumer price index that you realize we really have been living in a world of "two inflations" - tumbling prices for imported goods and rapidly rising prices for domestic goods and services.

Combine these two inflations and throw in the huge "shelter" component that neither rises nor falls much as home prices soar and then plunge and the result is "benign" inflation.

What Does This All Mean?

For years, persistently low and falling prices for imported goods such as electronics and apparel have been masking much higher levels of domestic inflation in areas such as medical services and household energy.

Any economist with a spreadsheet and a web browser could have confirmed that.

But, what is significant about this is that this phenomenon should have been factored into monetary policy over the last decade or so but it wasn't.

Low inflation, regardless of its source, was used as a justification for keeping interest rates too low for too long and the unfounded fear of "de-flation" was the reason cited for keeping rates at "freakishly" low levels for several years in this decade.

Yes, pegged currencies in Asia play a role here, but surely the folks at the Federal Reserve, even with their misguided focus on consumer prices to the exclusion of nearly all other considerations, could have seen that inflation in the U.S. was only as low as it was because of cheap imports.

Had this been understood and had interest rates been kept higher over the last ten years, we probably wouldn't have near the number of problems that we've seen in the last year or two.

Comments

[Leftfield:]

Like cockroaches, the lists of policymaker mistakes, while clearly huge at first glance, multiply at further glances. Here we see that relying on misguided government consumer inflation statistics to gauge actual inflation is even stupider than it looks at first glance. Domestic rises were hidden by import deflation. Why? Can so many people at that payscale actually be so dumb?

Sep 10 05:05 AM

[Moon Kil Woong:]

A very good article and argument. I suppose it's because it's very true. This low inflation due to imports phenomenom has just further fueled our addiction to low cost imports and made the Federal Reserve who knew what was happening and the government at large fear clamping down on imports since it would reveal out of control inflation and hasten a market downturn because interest rates would have to normalize to curb it.

The sad fact is that with short term rates stuck close to zero by the Fed and more and more banks and businesses becoming addicted to short term low rates, a normalization of rates back to any norm would probably floor the economy lower than the initial drop we saw at the start of this recession. Like Japan, we are becoming increasingly stuck at 0. And like Japan, we are liable to see how pernicious such a position is since it thwarts any future growth or prosperity going forwards. It's like tying a 50 pound weight on a persons legs and asking them to run.

But what's worse than Japan is even while we do this there will be a set of big yapping dogs chasing us (Those being a massive deficit, international creditors, and higher commodities prices). As a horror movie, it would not be hard to guess what happens to the hapless victim who gets stuck in such a position. So why can't and couldn't our policy makers see it coming? Why? Are they that stupid and blind?

Sep 10 05:12 AM

[markfl:]

I'm surprised the author didn't mention in more detail his own article from late August specific to the subject of owner's equivalent rent. seekingalpha.com/artic... The charts are very good, and they illustrate one of the single greatest economic policy blunders of this century: the idea that home prices should ever be excluded from inflation. If home prices (as measured broadly across the country) exceed significantly the CPI for an extended period during a loose Fed monetary phase there is potential for an inflationary bubble. The main reason is that many people have pay raises fixed to an artificial stat like CPI, and it tends to create a bidding war for what can be a scarce resource (affordable home ownership).

If you care to pick one of the main causes of this recession that would be one. If I could ask Bernanke one question it would be whether he ever noticed all the property ladder and house flipping tv shows a few years ago and what he thought of them and the so called "condo craze" in a number of markets. They were crazy all right. Mad. Insane.

Sep 10 05:36 AM

[markfl:]

Oops. Deja vu. I just realized Iacono's article wasn't two weeks ago, but two years ago! But wait! This was before this recession. It shows that the Fed is frequently out of phase with reality. They see deflation when home price inflation aggregated with CPI is peaking, and see inflation when the collapsing bubble should adjust aggregate inflation negatively.

Asset price inflation matters. Even "volatile" energy matters, because every out of pocket dime spent on energy is not spent on other consumer goods. No one can ignore the role of the gas price spike in contributing to economic downfall in 2008.

On Sep 10 05:36 AM markfl wrote:
> I'm surprised the author didn't mention in more detail his own article
> from late August specific to the subject of owner's equivalent rent.

Sep 10 05:51 AM

[User 353732:]

1. Ordinary homeowners have known for many years that the costs of home ownership has escalated far more rapidly than rents. These rising costs include property taxes, in most municipalities, that always go up even in violation of explicit formulas and caps ; in many zip codes fraudulent assessments by tax agencies keep going up while prices crash so property taxes rise while values plunge. This is a double insult to homeowners, esp. those who have paid off mortgages.
Home and personal property costs have also risen sharply in hundreds of zip codes in the past 5 years; in many utility franchises, utility (energy, water, sewage, waste removal) rates have also escalated astonishingly as a result of both indirect taxes imposed by counties and states and on expensive but totally useless regulatory mandates. Utilities are now thinly disguised tax collection arms of the welfare state and complicit agents of social engineering.
Even with no debt, the sum of property taxes, insurance costs and utility bills can make home ownership a real financial burden in scores of expensive zip codes, for families where the chief breadwinner is unemployed. Instead of being a haven in times of economic compression, the home itself has become a source of stress.
Positive cash flow from rental property that has a mortgage is almost impossible in most parts of the US. In several zip codes, rents cover 50 to 60% of the total cost of home ownership(of course there are exceptions but they are rare indeed).
When this rising or already very substantial cost of home ownership(including legacy debt service) is combined with still declining home values, it is hardly surprising that even millions of honorable, hardworking, people are forced to or tempted to just walk away from the home that was once part of their dream but now is a part of their nightmare.
The nightmare is very largely a creation of a Federal Govt induced housing bubble and a state, local, muni govt based tax based of property. expropriation
2. For tens of millions of ordinary Americans, the quotidian reality is rising food and beverage bills, health care costs , education costs and total costs of auto ownership(depreciation and amortization, insurance, maintenance, fuel).
The Govt may report(dishonestly) that inflation is tame or non-existent but many Americans witness and experience a different reality: owned shelter, transportation, essential goods and services, life and health maintenance and education costs have all escalated remarkably. The price of the most vital import(energy) is volatile but the trend is surely up. Other imported goods and services (except autos) have experienced considerable deflation but these constitute a modest part of total household spending or are episodic purchases that can often be delayed.
We have sustained the delusion, for many years that our material quality of life was steadily increasing . In truth, Govt and Wall St generated asset bubbles, witless borrowing, the money illusion of rising minimal transfer payments and relying on the labor and work of foreigners have disguised a grim and now manifest reality: as a society( expect the privileged top 10%) we consume far more than we can afford----or honestly deserve---- what we need to maintain a minimum standard of civilized living costs far more than we think and at every level Govt and its extensions( eg utilities, insurance companies, healthcare institutions) take far too much out of our earnings and deliver far too little value.

Sep 10 05:57 AM

[chap08:]

The distinction between imported and domestic inflation is important and something that has been reported, but largely ignored, for a long time. It is ignored by the deflation camp (among others). They argue that deflation is inevitable because e.g. capacity utilization is so low and unemployment high. Well, sorry, theses things have had little or no impact on CPI for a long time. Imported inflation (or rather deflation) has dominated the figures.

I see 2 key things changing here. One is that higher oil costs never really had a chance to work their way in to imported inflation. Even in the middle of the recession, oil cost more than it did while we were importing all this deflation. Any significant recovery will cause higher oil costs and higher inflation around the world. This is particularly important for imported goods because oil comprises a higher % of the total cost (due to low labor costs, shipping etc.). The second point is that the dollar will (hopefully) continue its decline against other currencies. This factor, on its own, could add ~10% pa on to the cost of imported goods.

These 2 factors will make a big difference to imported inflation, which is the main driver of CPI.

Sep 10 06:26 AM

[winnersdon'...:]

This is not meant to politicize this argument, yet the birthplace for this "miscalculation" once again, cannot be placed at the feet of the populace, rather must be attributed to government and the halls of congress.
When big government fails for whatever reason to call the shots correctly, there has to be some rationale behind it.
The young Harvard,Yale,Princeton and Columbia Phd's working in D.C. cannot all be that stupid.
Who benefited big from the erroneous inflation calculation??
Banks,Real Estate Attorney's,homebuilders, initially on the way up.
On the way down, many got trampled in the crushing momentum of the collapse.
Too many in Washington view the country as a giant, big screen, real life , 3D live "sporting event" exactly what Tim Iacono has deduced in his marvelous piece, without saying it outright.
In politics it's win at any cost, the end justify the means, but remember one thing, the manager and coaching staff is without a doubt alive and well, and headquartered in Washington D.C.

Sep 10 07:16 AM

[John Galt:]

Could higher domestic inflation be due to low US interest rates, lots of borrowing cheap money to fuel speculative excess? Our cheap traced back to the Fed was finding a place ( US products).

Our domestic money is speculated/bidding up our goods and services, while Asian products mainly from China ( and Japan) have a pegged undervalued currency.

Our high inflation of the past plus their low inflation of the past = moderate inflation. Good point and underrated point.

Sep 10 09:37 AM

[LongmeShortme:]

Nice article Mr. Iacona, worth the read. Keep on keeping on!

Sep 10 09:41 AM

[Living4Divi...:]

Tim - You wrote a superb article breaking down the components of CPI. I especially like how you detailed the impact of imported inflation versus domestic inflation.

I have bookmarked this article as a reference.

Good work

Sep 10 09:52 AM

[tripleblack:]

I agree, inflation is not an "internal" matter anymore.

Sep 10 10:06 AM

[tripleblack:]

Hmmm, however, I would NOT assume that the Fed and others in government were (and continue to be) unaware of the effect cheap imports (labor dumping, as it were) has on our inflation.

On the contrary, their full awareness of this reality explains a great deal about the policies pursued over the last several decades.

Sep 10 10:16 AM

[Skjellifetti:]

My cell phone holds more computing power than was available on most university campuses in 1970. The MRI machine that saved my wife's life didn't exist in 1970. A physician recently told me that the number of slices taken by medical imaging technologies, like Moore's Law for semiconductor density, doubles every couple of years.

To say that:

For the purposes of this discussion and as the source for all the charts that appear here, only original Labor Department data is used and all issues related to such things as hedonic adjustments, geometric weighting, and other factors that contribute to the "reported" rate of inflation almost always coming in lower than the rate of inflation experienced in the "real" world will be ignored.

means that your analysis is meaningless since you are comparing yesterday's apples to today's oranges by ignoring the huge technology growth that has occurred in many of the goods and services incorporated in the CPI. The "real" world does not stand still over time.

Sep 10 11:17 AM

[Living4Divi...:]

The truth is - no one seems to know what the future holds. Even the economists think we are in "uncharted territory" Still, when a nation runs up massive debt and prints a lot of money, inflation is usually the result.

Sep 10 11:55 AM

[nova:]

"owners' equivalent rent " was a great invention to defraud the general public.

The old saying goes: it is impossible to live in a socialistic state without cheating & stealing.

Sep 10 12:43 PM

[TeresaE:]

Too bad the charts/data don't extend into this year.

As a manufacturer of products that are now primarily imported, this is what I can tell you happens.

Once Asia (China) has the lock on a line of goods and they manage to decimate the American manufacturer, they start raising prices. A lot.

I am now seeing this with clothing, and while things can be picked up cheap through sales, the BASE price of items such as toddler clothes, pajamas and socks & underwear shot up by 20% this year over last.

China is raising all prices on things like nuts, bolts, band-aids, first aid cream, etc and the domestic manufacturers are slashing their prices to attempt to sell anything.

A couple of years ago I did some research, nearly 60% of components in cars are made outside of the US, so autos are not domestic anymore.

Nearly 70% of our PROCESSED food is imported from China. Yep, Mott's apple juice and Kraft Mac 'n Cheese is made in China. Prices have been skyrocketing for the past 2-3 years.

Over 50% of our OTC & prescription pharmaceuticals are imported from China.

As the value of our dollar falls this means the basics we all need will eat up more and more.

Once you through in the upcoming inflation due to loss of buying power, taxation, health care and Cap & Trade, you begin to wonder how will the majority of us afford to feed our families?

Oh, that's right, never fear, Washington is here.

Sep 10 01:42 PM

[NUCLEAR1929:]

i know only one kind of inflation, its when government says all is under control, then you go shopping and each time you shop, you pay more and more and more

Sep 10 02:17 PM

[Paul Fekula:]

Here's another thing to ponder... electronics are the very goods that would be most effected by hedonic adjustments. I have to think, when most people buy a TV or a computer, they maked their purchase based on how much money they plan to spend and don't consider the differences in performance, which are marginal at best. Is there really such a massive difference in the quality of the viewing experience between flat screen and tube tvs? Does the average person consider the MHz, gigabytes and and ram, when they just need a computer for work and the internet?

Sep 10 03:28 PM

[Mr. Big:]

Makes sense. Domestic inflation is high because of cheap credit supporting artificially high domestic demand (as someone mentioned earlier).

On imported inflation, before the crisis, there was huge demand for USD. The greenback was on a multi-year power streak. The large demand for USD makes imported goods cheaper due to increased purchasing power of the greenback.

Totally makes sense....

The scary part is.....it's all now reversing.

Sep 10 04:32 PM