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What Happened To Deflation?


It was just a few months back that deflation fears were all the rage in the financial markets and among policymakers. Investors, fearing that the U.S. economy faced a debilitating Japanese-style slide, drove down long-term interest rates, with the yield on the 10-year Treasury note falling to a 45-year low of 3.1%. To jump-start demand and keep prices from spiraling ever lower, Federal Reserve Chairman Alan Greenspan and his central bank colleagues cut short-term rates on June 25 to a decades-low 1%.

Now, the days of worrying about deflation are long gone. With the economy growing at a sizzling pace of 6% or more in the third quarter, the talk in the markets has turned to inflation. "Deflation had its 15 minutes of fame," says Sung Won Sohn, chief economist at Wells Fargo (WFC) Banks. Thanks in no small part to strong demand from China, commodity prices are soaring. Industrial materials are up over 50% from a year ago, with the price of everything from copper to cotton at their highest levels in years. Steel prices, too, are rising briskly, up more than 5% on many types in the last few months. Says U.S. Steel Corp. (X) CEO Thomas J. Usher: "We're seeing this recovery people are talking about."

Not surprisingly, those price hikes have led to a big rise in inflation expectations, as measured by the Treasury's 10-year inflation-protected securities. The spread between those bonds and their noninflation-adjusted counterparts has risen sharply, to 2.4%, in recent months. And some Fed policymakers, as well as U.S. Treasury Secretary John W. Snow, have begun to talk about the need for higher interest rates as the economy gathers steam.

PROS AND CONS

It's natural to expect price pressures to build as the economy recovers more strongly. In the past, that would have been a big concern because rising prices would be seen as a harbinger of a surge in inflation. But in today's high-productivity, low-inflation economy, a little extra pricing power may be just what U.S. businesses need. As demand rises and sellers gain clout, higher prices will boost profits -- and encourage companies to expand and take on more workers. "A rebirth in pricing power is a plus for Corporate America and the economy," says Morgan Stanley (MWD) economist Richard Berner.

Of course, there's always a risk that once it starts to pick up, inflation could spiral out of control. It takes 12 to 18 months for monetary policy to have its full effect, so while few, if any, economists foresee a big jump in inflation next year, some are worried that if the Fed waits too long to act, inflation could accelerate more than it expects. By keeping interest rates at such low levels, these economists fear, the Fed's hyper-accommodative policy could be storing up trouble for the future. "The Fed is now running an inflationary monetary policy," says Brian S. Wesbury, chief economist at investment banker Griffin, Kubik, Stephens & Thomson Inc. "That's risky."

For now, though, inflation remains very low. The consumer price index, excluding food and energy costs, stood just 1.2% higher in September than during the same month last year -- the lowest year-over-year rise since 1965. But there are scattered signs that companies are starting to regain some of the pricing power they lost in the 2001 recession. Semiconductor prices are on the upswing, helping the bottom lines of chipmakers. On Oct. 14, Intel Corp. reported that its profits more than doubled from a year earlier, as did those of Texas Instruments Inc. (TXN), which reported earnings on Oct. 20. Samsung Group impressed investors with its announcement in October that it expects the average selling price of its cellular phones to rise in the fourth quarter -- virtually unheard-of in a telecommunications business plagued with competition and overcapacity.

WIDESPREAD BOOST

Nor is the tech industry alone in seeing a pickup. 3M Co. (MMM), the $17 billion maker of consumer and industrial products, said on Oct. 20 that it eked out a 0.1% rise in U.S. prices in the third quarter. That may not sound like much, but it marked the first time since early 2002 that prices went up at all. "We keep working hard at that," says CFO Patrick D. Campbell.

The supercharged Chinese economy, of course, has played a big part in rising commodity prices as the country snaps up steel, copper, and other raw materials to fuel its surging factory output. Beijing has said China's economy grew at a spectacular rate of 8.4% so far this year -- and some experts think even that understates the case.

The pricing climb goes well beyond commodities. As companies have shut down plants or gone out of business, survivors are starting to get some extra leverage to raise prices. That's certainly the case in trucking. Consolidated Freightways went out of business last year, and survivor Arkansas Best Corp. (ABFS), based in Fort Smith, was able to take advantage of the opening by hiking third-quarter rates for hauling goods 6.5% over last year. A pickup in demand also helped.

So far, however, one sector has been noticeably absent from the party: Retailers and other companies that make consumer goods haven't been able to push through much in the way of price hikes. That has raised concern that they could face a profit pinch from rising materials costs. But if the economy stays strong, pricing power should reemerge there as well. This holiday season, for instance, increased demand and leaner inventories should allow stores to avoid a repeat of last year's rampant discounting.

To break out of the trap of consumer expectations of ever-falling prices, retailers such as the Gap (GPS) or Limited Brand Inc.'s (LTD) Express stores are launching premium sub-brands that don't carry the parent's brand name. In Gap stores, for instance, execs are quietly expanding the 1969 line of clothing and raising prices. No surprise there: 1969 jeans command nearly double the price of standard Gap jeans, while Express' recently launched Seven7 jeans bring about a 30% premium.

There's even a bright spot for carmakers. While no one sees an early end to Detroit's rebate war, used-car prices are rising. Mannheim Auctions Used Vehicle Value Index shows that such prices, which are often a leading indicator for the new-car market, bottomed out in April and have risen 3.4% since then.

ARE FEARS OVERBLOWN?

These incipient signs of inflation are prompting some nervousness in the bond market. Investors think the Fed will start raising interest rates next spring. But as Greenspan & Co. head into their Oct. 28 rate-setting meeting, they seem in no hurry to act. With the economy awash in overcapacity even after the growth pickup and with productivity strong, Fed officials think inflation fears are overblown.

Still, there's a recognition that the Fed will eventually have to raise rates as the economic expansion unfolds. That's why some officials are uncomfortable with the central bank's repeated pledge to keep monetary policy easy "for a considerable period." They've begun looking for an exit strategy to free the Fed's hand. It's not that they want to raise rates anytime soon. It's just that they want the leeway to do so when it proves necessary.

In the bad old days of the inflation-wracked 1970s and 1980s, any pickup in prices was something to be feared. In the new era of price stability, however, the Fed can be counted on to stop inflation before it skyrockets. That's why a rebirth of pricing power now is a welcome sign of an economy finally on the mend. By Rich Miller in Washington, with Michael Arndt and Robert Berner in Chicago, Cliff Edwards in Silicon Valley, Kathleen Kerwin in Detroit, and bureau reports


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