Yet again the Federal Open Market Committee (FOMC) voted to increase rates in their June meeting, with a rather optimistic tone on future US economic growth and labor market contraction. However, as the labor market continues to tighten, inflation has taken a step back the past few months. The headline consumer price index (CPI) inflation rate, which was close to 3 percent in February, fell to 1.6 percent in June. The personal consumption expenditures (PCE) price index (the inflation measure that the Federal Reserve prefers to use) also fell to 1.4 percent in May, the lowest level since November 2016. If unemployment is so low, why has inflation stalled?
The slowdown has concerned a number of economists and policy makers, while attributed it to various one-off events. President of the Federal Reserve Bank of Minneapolis, Neel Kashkari, was the only member of the FOMC to vote against raising rates. He cited the divergence between the tightening labor market and falling inflation rates as evidence that the economy may not be ready for another rate hike. Others, like Patrick Hacker, the President of the Federal Reserve Bank of Philadelphia, argues that wages and inflation will likely pick up in the short and medium term primarily due to the U.S. operating at or near full employment. It may not be immediate, but Hacker admits that when inflation does pick up, it could rise quickly, which helps explain why the Fed was still in tightening mode.
The inflation slowdown
We decided to investigate by looking at how both core and headline CPI inflation rates have fluctuated over the past three years. Core inflation, which omits volatile food and energy prices, has remained relatively constant. As shown in Exhibit 1 below, core inflation fluctuated between 1.5 to just over 2 percent since January 2013, trending slightly upwards since then. Headline inflation, on the other hand, fluctuated between 1 to 2 percent from January 2013 to October 2014, before falling to around zero percent until January 2016, thanks to the steep drop in energy prices. It started to surge in winter 2016 and eventually hit 2 percent. However, both headline and core inflation have slowed in the last three months.
Exhibit 1. Headline and core CPI inflation rates Source: Federal Reserve Bank of St. Louis Fred Economic Data
Cell phone plans used to be expensive
Per the FOMC’s meeting minutes, several members believe that the sharp decline in wireless telephone services is a one-off event, with the proposition that the inflation rate will rebound over the medium term. However, we are not so sure that low cell phone prices will in fact rebound.
Back in 2008, Sprint Nextel, AT&T, and Verizon Wireless all charged consumers for sending and receiving text messages. Typically, you would be charged around 20 cents for every message. If a customer didn’t want to pay for texts individually, some carriers offered monthly text plans at an additional cost. AT&T charged $5 per month for an extra 200 messages per month, or consumers could spend $20 more per month for unlimited texting.
For voice and data service, many service providers capped user minutes. If the consumer went over, they would pay a penalty. Using AT&T as an example, their lowest rate for a monthly 2G network plan (using the iPhone) was $59.99 in 2008. In return, the consumer would get 450 minutes, 5,000 night and weekend minutes, and 200 SMS text messages. If you wanted to upgrade to 3G network speed, that would cost ten dollars more, without the 200 SMS text messages – that would cost extra.
Today, the lowest plan for AT&T, excluding promotional offers, is $60.00 per month, which includes unlimited talk and text messaging to Mexico and Canada, as well as unlimited texting from the U.S. to over 120 countries. Not to mention there is no penalty for going over a data cap. In short, over the years, cell phone plans have become significantly cheaper, especially when considering the additional services that are provided. Today, many service providers are far more capable to handle large amounts of data thanks to technological advancement.
How much have prices fallen already? A lot
Looking at most recent data, wireless telephone services fell 13.2 percent year-on-year in June. The most recent reduction in cell phone pricing is likely due to competition among service providers – AT&T, Sprint, T-Mobile and Verizon. All have unveiled some type of “unlimited” data plans that have competed with one another, driving down prices for consumers. However, there are also more service providers entering the market, which is also driving down prices. Comcast, the television provider, introduced its new wireless service called “Xfinity Mobile”. Charter Communications Inc, a cable provider, is also in expected to enter the market next year. Not to mention there are hundreds of regional plans throughout the country that offer competitive plans.
As competition appears to be increasing among wireless service providers and new players enter the market, we are not so sure that this is a one-off event. Using data from the Bureau of Labor Statistics, wireless telephone service prices have steadily fallen nearly every month since October 2009. As shown in Exhibit 2, telephone services have plummeted in 2017. There will likely be some price rebalancing. However, the long-term evidence is clear, cell phone prices are historically low, and will likely continue to be low for the foreseeable future.
Exhibit 2. Prices of wireless telephone services, December 1997 = 100 Source: Bureau of Labor Statistics
How much of a drag were cell phone plans?
There are several items that go into the consumer price index, as calculated by the Bureau of Labor Statistics, the eight major ones being food and beverages, housing, medical care, apparel, transportation, recreation, education and communication, and other goods and services (with a number of sub-components in each). In order to get a better picture of what was behind the recent slowdown inflation we compared the most recent June numbers to data in February, when inflation peaked.
Headline inflation hit a 4-year high of 2.7 percent in February. The main drivers of this were housing, which contributed 1.35 percentage points, and transportation (mostly gasoline), which added 0.96 percentage points. Medical care and recreation categories together added another 0.39 percentage points. Even then, one of the major drags was in fact wireless services (a sub-component of education and communication), subtracting almost 0.09 percentage points from the inflation rate.
By June, headline inflation slowed to 1.6 percent, a 1.1 percentage point decline from February. The biggest reason for the slowdown was the fact that transportation now added only 0.08 percentage points to inflation compared to 0.96 in February, a decline of 0.88 percentage points. Wireless services fell further, now dragging down inflation by 0.24 percentage points, 0.15 percentage points worse than in February.
The rest of the decline was broad-based, with housing contributing only 1.27 percentage points (vs. 1.35 in February), medical care contributing 0.22 percentage points (vs. 0.30 in February) and recreation contributing 0.05 percentage points (vs. 0.09 in February). In fact, the only contributor that kept inflation falling further was food and beverages, which added 0.13 percentage points (vs. 0.01 in February).
So even if you strip out energy and food, as core inflation does, there was a significant slowdown in inflation. Core inflation slowed from 2.2 percent in February to 1.7 percent in June. While the decline in wireless services was a significant cause of this slowdown, more than half the decline came from a broad decline in inflation across several other categories.
Is low inflation the new norm?
In the case of cell phones, prices have fallen primarily for two reasons: competition and technology. More companies are gaining market share, forcing the competition to implement cheaper plans with more services. Technology has also advanced, allowing companies to offer these plans with low impact on their balance sheet. We have also seen similar price adjustments in the retail sector, with Amazon creating havoc for businesses ranging from clothing retailers to grocery stores.
Though in this case, Amazon effectively reduces competition as it is able to function with lower margins on its products and buys out its competitors. In short, we may be in a new era where low inflation rates may be the norm, as companies fight for consumers and large market share.
Why falling prices are not always a good thing
As a consumer, falling prices could be viewed as a positive development. However, there are problems with this picture. If prices fall, many consumers believe that prices will continue to fall, so they may hold off purchasing today and wait for tomorrow. Second, if prices get too low, businesses will generally have a difficult time making a profit, which will eventually cause them to lay off workers, increasing slack in the labor market. As a result, we typically see low growth rates, with low inflation rates. We have seen this type of pattern since the post-2008 financial crisis, something that former Treasury Secretary Larry Summers has called “secular stagnation”. In short, even though prices, like cell phone plans, are getting cheaper and benefiting consumers, aggregate economic growth eventually feels the brunt of the decline.
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