By KATHLEEN MADIGAN at The Wall Street Journal
Federal Reserve officials often note their concern about low U.S. inflation, which has been well below the central bank’s target for three years. That lament might surprise consumers who are paying more every year for cable services, car insurance and dental checkups.
Chalk it up to a divide between goods and services.
The overall inflation rate, which has been well below 2% a year, according to several price measures, masks a split between the two main categories of consumer products. Prices of goods have been falling for most of the current economic expansion, while the cost of services has increased, sometimes sharply. Over the 12 months ended in May, goods prices fell 3.3%, or 0.3% when food and energy are excluded. Services prices were up 2%.
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Much of the recent run-up in service inflation stems from the jump in rents. But service prices outside of rents also are increasing. The upward trend might signal the domestic economy has less excess capacity and labor-market slack than is commonly assumed. When the economy has a lot of unused capacity, businesses have less ability to raise their selling prices.
“Service inflation tells us the U.S. economy is in better shape” than total inflation does, said Aneta Markowska, chief U.S. economist at Société Générale. If so, Fed officials might be behind the curve when it comes to one of its policy mandates: price stability.
The inflation split is evident between goods and services that are somewhat connected. Buy a bottle of wine and uncork it at home and you are paying slightly less than you did five years ago, according to Labor Department data. If the same wine is served by a sommelier at a restaurant, you will shell out 12% more.
A new suit costs 3.7% less than it did five years ago for a man, and 3.5% less for a woman. Getting that suit dry-cleaned, however, will set you back 9.2% more.
Possibly the biggest gap is in entertainment. The price of a new television has tumbled nearly 58% over the past five years. The cable service that allows you to watch shows on the set costs 13.7% more.
Why do service providers have more pricing power than goods producers? Among the factors:
Lack of global competition. Goods inflation began to slow in the 1980s as imported merchandise penetrated U.S. markets at a rapid clip. Lower wages and fewer regulations allow foreign companies to produce goods more cheaply than U.S. manufacturers can.
U.S. service providers need only focus on nearby competitors, not what is going on around the world. When asked about the inflation split, 83% of economists surveyed recently by The Wall Street Journal said the lack of global competition had a “large” or “modest” impact in allowing service inflation to run hotter than goods inflation.
Rising labor costs. “Wage pressure will show up first in the service category,” said Rajeev Dhawan, an economics professor at Georgia State University. Labor costs in services are determined more by domestic job markets, he said, and U.S. labor markets are tighter than those in other countries.
The yearly growth in hourly service pay has outpaced the raises at factories, narrowing the gap between the average hourly wage at private service companies and at manufacturers. That trend should continue in coming years because the push to increase the minimum wage will mostly lift service pay. Service companies, such as McDonald’s and Wal-Mart, have recently announced pay raises.
Slower productivity. To be sure, technological advances and reliance on computers have improved productivity in many service industries. According to Labor Department data, productivity in trucking, software publishing and accounting increased in 2014 at faster rates than the 2.4% yearly advance in manufacturing.
For other services, however, “you cannot substitute labor with capital,” said Mr. Dhawan. Output per hour worked in service sectors like newspapers, engineering and air transportation declined or barely increased last year. If companies in these industries want to protect profit margins, they have to raise prices.
Because consumers pay service bills more often than they buy most goods other than food and gasoline, perceptions of inflation skew on the high side. Among consumers in a June CNBC survey who thought prices would increase in the next year, the median inflation forecast called for prices to rise 2.8%. A large proportion, 15%, thought prices would be up 11% or more.
That’s in contrast with the view at the Fed. According to the minutes of the Fed’s June policy meeting, the central bank’s staff projected that, because of slack in the resource and labor markets, inflation would continue to run below the Fed’s target of 2% from now until the end of 2017.
Rising price pressures in the service sector—which accounts for two-thirds of the U.S. economy—suggest that the economy might have less unused domestic capacity than the Fed thinks. If so, policy makers may find themselves in an inflation bind within the next two years.