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Inflation update

On a year-over-year basis, inflation according to the Personal Consumption Deflator remains within the Fed's target range.

On a shorter time frame, however, the pace of inflation is picking up. Over the past six months, the headline PCE deflator is up at a 3.4% annualized rate, and the Core PCE deflator over the past three months is up at a 1.9% annualized rate. The fact that both headline (total) and core inflation (ex-food and energy) are rising at a faster rate at the same time is consistent with the fact that the Fed is indeed in an accommodative mode, and willing (and wanting) to let all prices rise. They are getting their wish, which is not surprising. The rise in measured inflation is still relatively tame, however, but it will be very important to see how this unfolds in coming months.

This last chart shows the major sub-components of the PCE Deflator (services, durables, and non-durables). Since 1995, headline inflation has been subdued by a previously-unprecedented decline in durable goods prices (i.e., this is the first time in the history of this series that the blue line has declined on a sustained basis). It is probably not a coincidence that 1995 marked the first year in which China pegged its currency to the dollar (thus stabilizing and eventually strengthening it), which in turn set the foundation for strong export-led growth. This chart also helps explain why there is so much confusion over whether we should worry about inflation or deflation, since there is evidence of both.

The chart also tells a very interesting story. Since 1995, service sector prices have risen by 55%, while durable goods prices have fallen by 26%, for a 110% relative price change (this is roughly equivalent to saying that one hour's worth of work in the service sector today buys twice as much in the way of durable goods as it did in 1995). To the degree that China's exports of durable goods have contributed to this relative price shift, it is a testament to how the increased productivity of the Chinese workforce has resulted in a significant rise in living standards for workers in the industrialized world. Contrary to what uninformed critics say, global trade is a win-win situation for all concerned.

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