Inflation remains a problem — but not for goods

Even with goods prices falling, it’s unlikely that inflation will weaken much without consumers cutting back on services spending.
Executive Director, Research

Consumer sentiment is now lower than it was during the early days of the pandemic, and inflation remains one of the key issues bothering consumers. Despite it falling from a high of 9.2% in June 2022 down to 3.4% last month, inflation seems to be stubbornly stuck in the mid 3% range. The important thing to recognize is that it was always going to be easier to get down into the 3-4% range than get back to the Fed’s 2% target range (although to be fair, the 2% is the Fed’s preferred PCE measure, which is running below CPI levels). 



The rising goods prices we experienced in 2022 and the early parts of 2023, driven by supply chain issues and excess demand, were always going to cool. The $600 billion annual shift from spending on services to spending on goods, resulting from pandemic-led shifts in consumer behavior, was never going to be permanent. After all, spending has been steadily shifting away from goods towards services since the 1970s. And this is an important point. U.S. consumers spend almost 70% of their money on services. That means that services inflation has a much higher weight than goods inflation. So even with goods prices falling through the floor, it’s unlikely that inflation will weaken much without consumers cutting back on services spending.  

Lower goods prices are pulling inflation down  

Looking at PCE inflation, in three of the past six months we’ve seen year-over-year deflation in goods prices. In seven of the last 12 monthly readings, we’ve seen deflation in goods prices month-over-month. While inflation remains stubbornly above where the Fed would prefer to see it, goods prices have actually been pulling inflation downwards. PCE goods inflation was practically flat on a year-over-year basis in March, coming in at 0.1%. So essentially, there is no real goods inflation to be seen in the economy.  

If we look at individual product categories, we can see that a range of retail goods are experiencing deflation. All but one major goods category (depicted in Chart 2) is below the Fed inflation target. Education and communications commodities are down 6% year-over-year, with recreation, transportation and household commodities all down over 2% since last year. Items such as smartphones (-9%), toys (-8.2%), televisions (-6.9%) and major appliances (-5.8%) are much cheaper than they were a year ago. Of the 17 sectors depicted in Chart 2, which comprise 94% of total consumer spending, eight of the nine lowest are goods categories. 



Profit margins for retailers are shrinking

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As a result of the softening in goods prices, gross margins and profit margins are also falling for many retailers. Excess demand coupled with the shortage of inventory that we saw during the pandemic drove margins up as demand outpaced supply. This created a scenario where discounting and promotional activity was unnecessary to clear shelves. As inventory and demand levels have begun to revert to “normal” levels, retailers are once again discounting heavily, driving down profitability in what is already a low margin business.

As we look forward, it remains likely that goods prices will remain soft as consumers begin to pull back from their pandemic-fueled splurging. Consumers looking for the lowest possible prices in the face of ongoing high prices for rent, gas, insurance and other services will continue to create pressure on retailers who are already dealing with softening margins. While a soft landing for the economy remains a potential outcome, the reality for many retailers is that they could be in for a more challenging environment over the next 6-12 months. 

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