The Foreign Capacity MythGene Koretz
One of the oft-cited arguments against a coming pickup in inflation is that lower capacity use overseas will continue to keep a lid on U.S. import prices and thus reduce inflationary pressures. As a study by economist James A. Orr of the Federal Reserve Bank of New York indicates, domestic prices of manufactured goods in other industrial countries have trailed the rise in U.S. prices since 1990 by as much as 10% in the case of Japan. And import prices of such goods did indeed rise less than U.S. prices through mid-1994.
The problem, notes Orr, is that the effects of lower inflation abroad were substantially altered by currency movements. The dollar prices of manufactured imports from Western Europe and Canada actually fell by 7% relative to U.S. prices between 1990 and mid-1994, but that was mainly because the dollar appreciated against their currencies. At the same time, prices of Japanese imports rose by 6% more than U.S. products because the dollar depreciated by 17% against the yen.
The upshot of these trends in which rising dollar prices of Japanese products offset lower prices of imports from Canada and Europe is that U.S. import prices overall grew only 1% less than U.S. domestic prices. Without currency shifts, however, Orr calculates that U.S. import prices would have trailed domestic inflation by a hefty 5%.
In other words, in a world of shifting exchange rates, spare capacity overseas may exert little or no downward pressure on U.S. prices. Indeed, import inflation has already picked up substantially in recent months--a trend that rising capacity use overseas in coming years may well exacerbate.