On Thursday, the Bureau of Labor Statistics (BLS) released the January Consumer Price Index Summary. The reported inflation numbers were within market expectations. Overall inflation showed that year-over-year prices have increased at 7.5 percent. As has been widely reported, this is the highest inflation has been since 1982. In our last post on inflation, we highlighted how the increase in M2 may be fueling the rise in prices. In this post, we will discuss how the change in the composition of demand is contributing to higher inflation. The figure below depicts the CPI inflation and another measure of inflation PCE-inflation (Personal Consumption Expenditures).
As you can see, these series are highly correlated. In this post, I will use the PCE-inflation to highlight how the increase in demand for goods (relative to services) is contributing to the rising prices.
At the pandemic’s start, consumption of goods and services dropped dramatically. However, as the economy opened up, consumers shifted their consumption toward goods and away from services. Recall households were reluctant to eat out, go to the movies, attend shows, or spend on a wide range of activities where people would gather together in crowds. Instead, households bought more goods; perhaps they bought a new TV, a new computer to work from home, or other goods that made staying at home more enjoyable and, for those working at home, made their time working more productive. The figure below highlights this shift from consumption of services to the consumption of goods. In this figure, we normalize spending on goods and services to 100 in February 2020 so that changes in spending can be thought of as the percent change relative to spending before the pandemic. For example, in April of 2021, consumers were spending 33.7 percent more on durable goods than in February of 2020. We can see in December of 2021, consumer spending on durables remains elevated (15% higher than 2/2020), whereas spending on consumer services is not quite yet back to its pre-pandemic level (0.70 percent below).
If goods production cannot respond quickly to the increased demand and supply chain disruptions slow down production, these factors will increase the price of goods. The figure below shows that year-over-year goods prices have increased by nearly nine percent (9%). For nearly the last decade, the percent change in the prices of goods was close to zero or negative. However, during the pandemic and the recovery, the increase in goods prices has risen at a rate faster than what we have seen in nearly 40 years. There has been an increase in service prices as well. Over the last decade, service prices have increased at a little over two percent per year, but the most recent PCE data release indicates services prices are up over four percent.
Looking forward, if the demand for goods remains elevated and if there are continued supply chain issues, we can expect inflation to remain at elevated levels. If the demand for goods falls and if the supply chain disruptions are mitigated, we may see some downward pressure on prices, and this may ease inflation in 2022.
