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short essays and reports on the economic issues of the day
2005 ■ Number 18

Closing the Gap
Riccardo DiCecio
popular measure of inflation is based on the consumer
a low and stable value of overall inflation, which is a weighted
price index (CPI). The total CPI measures the price
average of goods inflation and services inflation. This rules
of a market-based basket of goods and services, relative
out the possibility that both goods and services inflation rates
to the base year. Core CPI inflation is the year-over-year rate
increase or decrease indefinitely. Core CPI inflation could be
of change of the CPI, excluding food and energy commodities
stable with goods inflation and services inflation moving in
and energy services.
opposite directions indefinitely. However, this would imply
that either goods or services prices would eventually become
The core CPI inflation rate is an aggregate measure and
therefore hides important differences between goods and
In summary, even if goods and services inflation rates
services with regard to the behavior of inflation. Between
behave differently in the short run, they cannot diverge indefiJanuary 1968 and April 2005, the price of services (excluding
nitely because monetary policy puts a constraint on their
energy services) grew at an average annual rate of 5.55 percent.
weighted average and prices cannot be negative. ■
Over the same period, the price of goods (excluding food and
energy commodities) grew at an average annual rate of 3.27
1 For details on different measures of core inflation, see Kristie M. Engemann
percent. In other words, the price of services, relative to goods,
and Michael T. Owyang’s “Hard ‘Core’ Inflation,” Federal Reserve Bank of St. Louis
grew at an average annual rate of 2.27 percent over the past
Monetary Trends, February 2005.
37 years.2
2 This increase in the relative price of services is a well-documented fact and is
In the 1990s and early 2000s (between the two vertical lines
believed to be caused by differences in total factor productivity across sectors.
3 Peach, Richard W.; Rich, Robert and Antoniades, Alexis. “The Historical and
in the chart), goods and services core inflation rates were
Recent Behavior of Goods and Services Inflation.” Federal Reserve Bank of New
extremely different. Core goods inflation declined sharply
York Economic Policy Review, December 2004, 10(3), pp. 19-31.
from around 4 percent to –2 percent. Core services inflation
hovered around 4 percent. The difference between the two
core inflation rates widened from 0 to 6 percent.
This widening gap has provoked opposing views.
Some have argued that a high sustained rate of inflaCPI Core Inflation Rates (seasonally adjusted)
tion for services could drag the overall inflation rate
Year-Over-Year % Change
upward. Others fear that declining prices of goods
could trigger a general deflation.
Peach, Rich, and Antoniades observe that, while
the gap between services and goods inflation rates
moves around in the short run, it has a tendency to
return to a constant equilibrium value in the long
run. The recent behavior of core goods and services
inflation confirms their finding. In the past two years
the gap has returned to its long-run value, with a
decline in services inflation and a sharp rise in goods
The long-run behavior of the gap between services
and goods inflation is not surprising. The monetary
policy stance determines the overall inflation rate.
One of the objectives of monetary policy is to keep
SOURCE: Bureau of Labor Statistics.
prices stable. A successful monetary policy enforces


Views expressed do not necessarily reflect official positions of the Federal Reserve System.