Amazing Changes In Relative Prices

by: Calafia Beach Pundit

According to the Personal Consumption Deflator, inflation in November was almost nonexistent. In fact, inflation over the past year has been a mere 0.9%. That's less inflation than the Fed wants, and it's one reason the Fed has not already ended its QE3 bond purchases - presumably the Fed is concerned that inflation is "too low" and deflation is uncomfortably a risk. I've argued before why deflation is not really a risk or a significant concern, and this post adds another reason to the list: deflation is largely confined to the durable goods sector, and it's not the result of deflationary monetary policy.

The first of the above two charts shows the year-over-year change in the headline and core measures of the Personal Consumption Deflator. On a year over year basis, headline inflation has dipped to just below the Fed's desired target range. But as the second chart - which shows the six-month annualized rate of inflation according to these same two measures - shows inflation on a more coincident basis is running at a 1.3% annual rate. That's pretty close to nirvana in my book.

The above chart shows the major components of the Personal Consumption Deflator: services, durable goods, and non-durable goods. All three are indexed to 100 as of the end of 1994. I chose that date because it marked the beginning of what has now been an unprecedented, 18-year decline in durable goods prices. It's not a coincidence that that date also marked the beginning of the Chinese yuan's 18-year rise against the U.S. dollar and China's export boom, which flooded the world with cheap manufactured goods. The early- to mid-1990s were also a time when computers began spreading like wildfire and the modern internet was born. 1995 was like the Continental Divide, when manufactured goods prices started going in one direction (down), while service sector and non-durable goods prices went in the other direction (up).

The story is relatively simple: technology, coupled with the rise of China's manufacturing prowess, have driven down the prices of manufactured goods at the same time that they have boosted the productivity of labor. Labor is much more productive today, thanks to computers, technology and the internet. So productive, in fact, that it takes less and less input from people to make more and better things.

Durable goods prices have fallen by 30% in the past 18 years, while the prices of services (a reasonable proxy for labor costs) have risen by over 60%, and non-durable goods prices have increased by about 50%. Looked at another way, service-related prices have risen by almost 130% (i.e., they have more than doubled) relative to durable goods prices.

This has led to the most amazing change in relative prices in modern times, and it's a gift that keeps on giving to the vast majority of the population: A typical wage today buys more than twice as much in the way of durable goods as it did 18 years ago, and there is no sign that this won't continue.

Most important fact of all: Monetary policy has had little if nothing to do with durable goods deflation. It's all about China opening up its billions of people to the global marketplace, the blossoming of international trade and the technological wonders released by the combination of ever-more-powerful computer chips and incredible software technology.

This is not something to fear, this is something to celebrate.