Earlier this week the Bureau of Labor Statistics released its October update of the U.S. terms of trade. This is an obscure little index that economists use in order to measure the value of trade between two jurisdictions. Its actual use is relatively limited, but one of the applications is as an indicator of imported inflation.
Back when America was badly dependent on imported oil, we all know what happened to the gas price as global oil prices increased. The connection still exists between the global market and what we pay at the pump, even though we still benefit to a large degree from our recent gains in energy independence. However, there is more to the oil-price story, namely U.S. exports: we sell a lot of stuff abroad, and at least in theory those exports pay for our imports from that same country.
This is where the “terms of trade” index becomes relevant. It reports the ratio of U.S. exports prices to U.S. imports prices, showing us whether or not the imports from a country are becoming cheaper or more expensive, relative the products we export to them. If
- our exports become more valuable, in other words if buyers in the other country pay more for the products we export to them,
- while we still pay the same price for whatever we import from that country,
then our terms of trade with that country have improved. We are getting their goods relatively more cheaply than before.
The same improvement in terms of trade happens, of course, if import prices fall while our export prices remain unchanged (or increase). The key point here is that an improvement in the terms of trade – a rise in the index number – is an indicator we are not importing inflation, while a drop in the the index number indicates that we are importing inflation.
One of the arguments around our current inflation experience is that it is linked to global supply-chain problems. Specifically, it would somehow be connected to the clog-up of cargo ships off the California coastline, unable to unload imported products from China. For this argument to be valid, we must see a drop in U.S. terms of trade vs. the rest of the world in general and vs. China in particular. Bluntly: if the argument is valid that the global supply chain is causing our inflation, the prices we pay for imports must be rising relative our exports.
Well, as it turns out, that is not what is happening. As Figure 1 reports, our terms of trade with China, Japan and the European Union have improved consistently since the end of last year:
It is important to note that the terms-of-trade calculation only takes account of good trade, not services; inflation imported with services bought from abroad is not taken into account. At the same time, services are only 15 percent of our imports and 30 percent of our exports; the terms-of-trade calculation is still a good gauge of any inflation pressure from abroad.
The three jurisdictions reported in Figure 1 account for 41.6 percent of all our goods imports and receive 29.4 percent of our goods exports. That is a substantial share of our foreign trade, and with our two major trading partners in Asia accounted for, it is safe to say that inflation is not being imported through the clogged-up harbors in California. We get 18.5 percent of our imports from China and 5.4 percent from Japan.
The only major trading partner with which we have seen a deterioration in terms of trade – in other words from which we might be importing inflation – would be Canada. They are substantially less important to us, selling us only 11.8 percent of all the goods we buy from abroad. Therefore, the 11.4-percent decline in our terms of trade with Canada cannot be responsible for more than a marginal share of any of the inflation we are currently experiencing. It is also worth noting that with terms of trade improving with larger trading partners, any inflation imported from Canada would be more than compensated for by the improvement in our real exchange rates with Europe, China and Japan.
The numbers presented here do not tell the whole story about imported inflation, but they tell the large majority of it. Anyone still claiming that our inflation is a supply-chain problem will have to explain how that is possible even as our terms of trade improve with major trading partners, with our industrial capacity utilization being below where it was two years ago and with our workforce being short 5.6 million people before it reaches its 2019 capacity.
No, our inflation is the result of large budget deficits being financed by the Federal Reserve. It’s not more complicated than that.