Economics and Strategy

U.S. Outlook – U.S. Inflation in a Globalized World

The increased reliance on imports of manufactured goods over the past few decades has changed the underlying dynamics of U.S. inflation. Headline inflation has become heavily influenced by the behavior of import prices which, in turn, are very sensitive to global economic conditions and commodity prices.

U.S. inflation, as measured by the year-over-year change in the headline CPI, has averaged 1.5% since the beginning of 2015, which marked the end of the second deflation wave of this cycle. In April 2015, the year-over-year change in the headline CPI was running at -0.2% due to a strong disinflationary wave in the second half of 2014. After the disinflationary effects abated, the headline CPI accelerated to as high as 2.9% in June and July of 2018 before again decelerating to as low as 1.5% year-over-year in February of this year.

Core measures of U.S. inflation have been significantly more stable than headline measures. The year-over-year change in the core CPI went as low as 1.6% in January 2015 but accelerated to as high as 2.4% in July 2018 before decelerating again to as low as 2% in March of this year. Core CPI inflation has averaged 2% since the beginning of 2015.

The moderate behavior of core inflation relative to headline inflation is primarily a function of the behavior of service inflation relative to manufactured-goods inflation. Service inflation is primarily a function of domestic conditions. Service inflation has gradually and erratically accelerated this cycle from the historic lows. Service inflation in the CPI has averaged 2.7% since the beginning of 2015, ranging from 2.1% to 3.1%, and remains moderate by historical standards with relative stability.

Intuitively, it makes sense that service inflation would accelerate during a 10-year expansion in an economy that is overwhelmingly dominated by the service sector. More than 86% of private sector payrolls are involved in the service sector of the U.S. economy, which is also very domestically oriented. Service exports averaged a modest $69 billion per month in 2018, and imports averaged a very moderate $46 billion per month. Consequently, U.S. service prices tend to be domestically determined.

This domestically-oriented determination of U.S. service prices contrasts sharply with the determination of U.S. manufactured-goods prices. The good-producing sector of the U.S. economy has declined substantially as a share of economic activity. While the share of service sector payrolls has risen from roughly 60% to more than 86% in the U.S., the goods-producing share of private sector payrolls has declined from roughly 40% of payrolls to about 14%. The decline in the U.S. goods-producing sector was primarily a function of the decline in U.S. manufacturing activity during this era of globalization. The U.S. effectively outsourced a significant portion of U.S. manufacturing activity. This outsourcing of manufacturing activity has both had effects on the nature of U.S. growth and has caused growth to be slower but more prolonged.

The decline in the U.S. goods-producing sector has also changed the inflation dynamics related to manufacture goods prices for the simple reason that the U.S. imports of manufactured-goods have increased massively—averaging $214 billion per month during 2018, the U.S. imported more than $2.5 trillion of manufactured-goods from overseas last year.

As U.S. imports of manufactured-goods have risen, there have been two important changes. First, the effect of import prices on U.S. inflation has also increased substantially. Second, inflation in the U.S. has become more volatile due to the increased importance of global economic conditions on import prices. As a result, the magnitude of the oscillations in U.S. manufactured-goods inflation during the era of globalization has increased significantly, and the frequency of these oscillations has also increased.

The movement in U.S. manufactured-goods inflation is very highly correlated with import prices, and the correlation is strong whether energy prices are included or not. Import prices, in turn, tend to be sensitive to global economic conditions, which is why import prices tend to move with commodity prices.

The bottom line is that U.S. headline inflation will follow import prices which, in turn will follow commodity prices. Manufactured-goods inflation reflects the change in the structure of the U.S. economy during this era of globalization and tends to be dictated by global economic conditions because a massive amount of the goods that are consumed in the U.S. are imported from overseas.

— Ward McCarthy, Chief Financial Economist