An Overlooked Inflation Indicator Is Going the Wrong Way (August 20, 2023)

Import prices jumped in July, a sign that goods-price deflation may be stalling or reversing

By Lisa Beilfuss
August 20, 2023

A key assumption behind inflation optimism may be less reliable than many investors believe.

The Labor Department said that import prices rose 0.4% in July from a month earlier, double the rate economists expected and the biggest increase since May 2022. While one month doesn’t make a trend, the July gain follows an upward revision in June and may represent an inflection point. 

Compared with other inflation gauges, the import price index commands little attention. One reason is because, naturally, the index is heavily weighted toward manufactured goods. Though the U.S. economy is tilted toward services, the goods-producing sector still represents about a fifth of gross domestic output. 

In addition to final-goods imports from cars to toys, a significant share of inputs for domestic production and consumption are imported. For context, the Commerce Department has said that only about half of total U.S. end-user demand for manufactured goods is domestically produced. The import price index is thus an underappreciated leading indicator for inflation as import prices affect producer prices and, ultimately, consumer prices. 

Falling goods prices have been something of a foregone conclusion across Wall Street. Even as economists and investors debate the path of inflation, interest rates, and whether the U.S. economy will land softly or with a thud, one thing that virtually everyone has agreed upon is that goods prices would deflate after surging during the pandemic. 

This all matters because goods-sector deflation has been expected to partially offset stubborn service-sector inflation, which has remained elevated in part because of short labor supply and generous fiscal spending. 

Until now, that proposition has mostly played out as expected. Looking back to July 2022, import prices fell month-over-month in 10 of the last 13 months. Over the same stretch, the index of durable goods in the consumer price index fell eight times from a month earlier. Stalling or reversing goods deflation now would leave that durables basket in the CPI up 22% from December 2019, down only slightly from a year earlier when those prices were up 24% from pre- pandemic levels. 

The reason some investors might be inclined to disregard the July rise in import prices is the same reason they should heed it. The fuels category rose a hefty 3.6% last month from June, pushing up the overall index. While economists and central bankers tend to exclude energy and food prices from inflation figures, the reality is that businesses and consumers can’t ignore the cost of essentials. Energy prices have posted double-digit percentage increases since June and some analysts expect further gains. 

Eric Nuttal, portfolio manager at Nine Point Partners, predicts historic inventory drawdowns will push crude oil up to $100 a barrel this year, up 24% from current levels. He notes global oil inventories are at an eight-month low and expects them to end the year at an eight-year low. Even if the International Energy Agency’s estimate for oil inventory drawdowns over the second half of this year through the end of 2024 is only half right, inventories would fall to the lowest level since 2007, he says. 

Economic weakness in China is a potential wildcard. While weakness there and elsewhere would inevitably hurt demand, Nuttall points to real-time data from research company Rystad Energy as evidence that oil demand in China and beyond has yet to falter. 

A related point: A downturn in China would seem to offer a silver lining for the U.S. in the form of exported deflation. But that effect may be less pronounced than many strategists expect. Recent trade data show that China’s share of U.S. goods imports fell to 13% in the first quarter, down from a peak of 22% in 2017 and putting China’s market share in the U.S. on track for the lowest annual level since 2004. Moreover, the price of imports from China fell in July at half the prior month’s rate. 

The recent rise in U.S. import prices isn’t only an energy story. Non-energy related import prices were flat in July for the first time since January, with the overall report signaling that deflation is gone from the import price index, says KPMG economist Meagan Martin-Schoenberger. Foods, building materials and transportation equipment, to name a few, rose respectively 2.5%, 1.6% and 1.4% in July from a month earlier.  

If import prices are an upswing, the impact on more closely watched inflation metrics may be bigger than what historically has been normal. Last August, researchers at the Federal Reserve Bank of New York found that the pass-through of import prices to the domestic producer price index more than doubled after the onset of the Covid-19 pandemic.  

Normalized supply chains have probably reversed some of the heightened correlation between import prices and producer prices. But some supply-chain issues persist while others may be reemerging.

Container freight rates from China to the U.S. have increased slightly in recent weeks, says Apollo Global Management chief economist Torsten Slok. The National Association of Realtors recently said home builders are still dealing with a shortage of distribution transformers, or devices that transfer power from the electrical grid to homes and other buildings, notes Bleakley Financial Group chief investment officer Peter Boockvar. The United Auto Workers (UAW) may strike, a major trucking company (Yellow) recently declared bankruptcy, and commodities remain disrupted by the war in Ukraine. The New York Fed’s global supply chain pressure index, while down significantly from a pandemic peak, has risen for the past two months.

The New York Fed researchers didn’t study the relationship between import prices and consumer prices because, unlike with the PPI, there isn’t a clear mapping between international products and domestic industry categories. But it is fair to assume that a renewed rise in wholesale prices would at least partially flow through to consumers. Consider a December 2021 survey by the Federal Reserve Bank of Richmond that found 80% of firms raised prices in response to their own cost increases. The balance absorbed higher costs, often by sacrificing margins. 

While often overlooked by media and market strategists, the import price index is worth watching in the coming months. The biggest upside risk to inflation isn’t from goods, but a premature reversal in goods-price deflation would upend inflation assumptions. Without that partial counterforce to sticky service-sector inflation, it may be harder than otherwise believed for inflation to glide back to target and for the Fed to begin cutting rates in early 2024.