Goods are getting cheaper. Services aren't

US consumer prices rose 7.1 per cent in the year to November, and markets took the figure with relief, mainly because core goods prices fell outright by 0.5 per cent on the month. Used cars, clothing and household appliances have finally given way to inventory clearance and unclogged supply chains. Equity bulls calling the end of inflation are celebrating the easy half of the adjustment. Goods are getting cheaper. Services, which make up most economic activity in developed economies, remain tied to wage growth.

The split shows that prices are moving at two speeds after the pandemic. Falling goods prices are mostly a story of supply recovering. Container rates are back to pre-pandemic levels, chips are plentiful again and retail inventories are bulging. Core prices, which exclude food and energy, rose 0.2 per cent in the month, the slowest pace since the summer of 2021, and 6.0 per cent over the year.

How the glut arrived

The goods reversal was set up by the mistakes of last year and this spring. Retailers, burnt by empty shelves in 2021, over-ordered just as shoppers turned from sofas and televisions back to restaurants and travel. Target and Walmart both warned in the first half of this year that they were carrying too much stock and would cut prices to shift it. Those markdowns are now showing up in the index, and they will keep doing so until warehouses are back to normal.

That makes the goods decline real, but also finite. Discounting to clear surplus inventory is a one-off adjustment to the price level. Once the surplus is gone, goods prices have no particular reason to keep falling.

Services can't be shipped

Core services excluding housing reflect workers' bargaining power, commercial rents and contract renewals. A flat-screen television or an imported sofa can come from a cheaper producer across the ocean. An hour of legal advice, medical care or air-conditioning maintenance cannot.

Service contracts reset every year or six months, building in last year's pay rises and the inflation that businesses expect. Because services are consumed locally and use a lot of labour, their prices change direction slowly.

Many service prices are also set on annual calendars that ignore the monthly data. Health insurers reprice premiums once a year, hospitals and doctors negotiate fees with insurers on multi-year contracts, and Medicare updates its payment rates annually. Last year's cost increases therefore surface in this year's prices, whatever has happened to container rates in the meantime.

The link to pay is direct. Average hourly earnings rose 5.1 per cent in the year to November, and in a haircut, a hotel stay or a hospital visit the wage bill is most of the cost. A services business facing that rise has three choices: raise prices, accept thinner margins or employ fewer people.

A currency tailwind that fades

The goods decline has had help from the exchange rate. The dollar rose to a two-decade high against a basket of currencies in late September, which made imported televisions, clothing and components cheaper in dollar terms at the very moment supply chains were clearing. Since then it has fallen back noticeably, and import prices respond to the currency with a lag of several months.

That means part of the goods deflation now in the index was set up by a dollar that has already turned. If the currency keeps easing, importers will face higher costs next year just as their inventory glut runs out, and one of the forces holding goods prices down will have gone into reverse.

Two decades of cheap goods

The pre-pandemic world offers a useful benchmark. For most of the twenty years before 2020, core goods prices were flat or falling, helped by China's entry into the World Trade Organisation and ever-longer supply chains. Core inflation hovered around 2 per cent in those years only because falling goods prices offset services prices rising well above that. If goods return to their old habit of mild deflation, services will need to slow a long way before the Fed's target is in reach.

Who gains from the split

The two-speed pattern redistributes pain. Retailers of discretionary goods face shrinking margins as they discount to clear stock, while their customers enjoy lower prices on the items they buy least often. Households, meanwhile, keep paying more for the things they buy every month: rent, insurance, childcare, meals out and medical care. For lower-income families, whose budgets lean heavily on rent and essential services, the goods deflation offers little relief.

Service businesses are split in turn. Those with pricing power, such as hospitals and insurers, can pass wage increases on. Restaurants and hotels, facing customers who have begun to resist higher prices, absorb more of the cost in their margins.

Where inflation settles

The question for the Federal Open Market Committee is where headline inflation ends up once the fall in core goods prices has run its course. If goods prices merely stop falling and level off, the headline index will be left facing services prices compounding at 5 per cent a year.

The optimists have one good argument. Housing costs, the biggest single part of services, are measured with a long lag, and rents on new leases have already slowed sharply, a point Jerome Powell made in a speech at the end of November. Shelter inflation should therefore fade over the coming year. That helps the headline, but it leaves the labour-intensive services outside housing, the part the Fed now watches most closely, untouched.

The indicators to watch are the monthly figures for core services excluding housing, the Employment Cost Index at the end of January, and the Fed's own projections, due with its decision this week. A committee that expected services to cool quickly would pencil in cuts for next year. One that did not would keep its projected peak rate high and say little about easing. Markets expect a half-point rise on Wednesday, which would take the target range to 4.25-4.5 per cent.

A policy rate of 4.5 per cent is enough to hit spending on cars, furniture and other durables. It is too blunt to cool demand for services without doing real damage to the labour market. Cheaper goods buy the Fed a temporary truce on inflation, but the fight will not be won until services prices come down, and that probably rules out any rate cut for a good while yet.