The fever has broken.
For some 20 years, the U. S. economy has been afflicted by a seemingly incurable case of inflation. Since 1973, core inflation--the increase in all consumer prices except food and energy--has spiraled up by 4% or more each and every year. Even the savage recession of 1981-82 couldn't drag inflation below this level. For an entire generation of Americans, persistent inflation is all they've ever known.
Get ready for a change. Since February, 1991, core inflation is running at an annual rate of only 3.1%, according to the latest government figures (charts). That's down from 5.2% in 1990. Inflation next year, most forecasters say, will run between 3.5% and 3.8%. "Core inflation is drifting down, and we've broken the 4% barrier," observes Donald Ratajczak, an economist at Georgia State University and a leading price watcher.
The inflation slowdown could last well into the 1990s. The key reason for optimism: Service-sector inflation, troublesome for most of the past decade, at last appears to be moderating. In part, that's because the recent recession forced a wide range of service businesses, from restaurants to apartment buildings to hair styling, to hold down prices. But even as the economy starts to recover, banks, insurers, ad agencies, and others are being forced to become more competitive by cutting costs and laying off workers with a vengeance. This promises to boost productivity, lower costs, and lessen the need to increase prices. As a result, says Morgan Stanley & Co. senior economist Stephen S. Roach, "we could be moving into an era of 3%-to-3.5% inflation."
WISHFUL THINKING? True, not everyone believes these gains will be lasting. The bond market, for instance, is still worried about prices surging after the economy begins to recover in earnest. "The collective memory is a world of high inflation and a tendency for it to accelerate," notes David Resler, senior vice-president at Nomura Securities International Inc. Bond traders "can't remember times when inflation was 2% to 3%," says Resler. Until the bond market is convinced that inflation has been dampened for the foreseeable future, real interest rates will remain high.
Low inflation is no stranger to manufacturers. At the high-tech end, computer prices have been on the wane for years, squeezing the industry while benefiting consumers. Over the past year, for example, personal computer prices have dropped by 8.2%, according to Store Board, a firm that tracks sales of personal computers sold through computer stores. Prices for some basic products are falling as well. Steel prices are now at their lowest level in 10 years, and so is the price of wallboard, reports USG Corp., the big Chicago-based building-supplies company.
Or take the auto industry. While sticker prices on new cars have roughly paralleled the consumer price index since 1981, the actual transaction prices in recent years have lagged far behind. Since 1988, for example, the price paid by car buyers has risen at an annual rate of only 2.1%, far less than the overallinflation rate of 4.9%. And while auto makers, such as General Motors Corp., have announced 3% price increases for their 1992 models, that's more hopethan reality. "These prices won't stick," says Wertheim Schroder & Co. analyst John Casesa. "We now have 42 nameplates competing in the most competitive market in the world in the middle ofa recession. It's impossible to pass along a meaningful price increase in this environment."
For the first time in years, service businesses are tasting the price pressures that have wracked manufacturers. Take housing, which makes up more than 40% of the CPI. Over the past three months, housing costs have risen at an annual rate of only 2.1%. No one expects a quick recovery in prices, given the severe slump in the housing market. Look around Boston. There, two-bedroom apartments that once rented at $1,200 to $1,300 a month are now going for as little as $795. "Rents have declined 10% to 30%," says Michael Polacco, president of Boston-based Popular Properties Realty Inc.
Medical care is another service that consumers must dig deep in their pockets to buy. Years of effort by the government and private insurers to slow inflation of health care prices finally seems to be having some effect. Over the past three months, the inflation rate for medical care has run at about 7.3%. That's high, but it's less than the 10.2% being recorded just nine months ago. Moreover, the price of X-ray machines and other sophisticated medical equipment has risen only 1.9% over the past year, the government reports.
On a smaller scale, this goes for personal services, too. The cost of hiring someone to do home repairs has risen at an annual rate of just 1.6% this year. At Jeannie's Hair Design, a San Francisco neighborhood business, the price of a basic haircut usually goes up $1 a year, reports owner Jeannie Mock. But not this year. "I just didn't do it," she says. "My rent hasn't been raised. I didn't need to increase my prices."
In a chain reaction, businesses that are having trouble raising prices are forcing their suppliers to hold down prices as well. At Michela's, a Cambridge (Mass.) restaurant, General Manager Christopher Myers renegotiated contracts for linen, floor maintenance, and cleaning supplies. The one supplier that refused to budge was replaced earlier this year. The result? "We probably cut our product costs for dishwashing and all the products we use around the restaurant by 35%," says Myers.
Nor will corporations pay top dollar for legal services anymore. "Over the past two years, we have seen law firms being more willing to enter into agreements with lower rates," says Jed Ringel, president of Law Audit Services, a New York-based legal billing consultant firm. Even after the recession is over, says Ringel, the pressure on fees will continue. "The myth has been broken that this is not a business."
The main force holding down service-sector inflation over the long run will be the need to stay in business. Right now, there are too many banks, retail stores, and office buildings. In some cases, the answer is mergers and consolidations. The three recently announced megabank mergers (page 24 30 ) will cost at least 26,000 jobs as the merged companies eliminate overlapping operations.
RUDE SHOCK. Hard as it will be on those who get pink slips, these cuts will improve the inflation outlook twofold. First, added unemployment will hold down wages. And with fewer hands doing more, productivity will jump. Morgan Stanley calculates that nonmanufacturing productivity rose by 1.3% in the second quarter. That's a staggering achievement next to the last two recessions, when it fell sharply. "Bittersweet consolation to the white-collar workers who are the victims of restructuring," says Morgan Stanley's Roach, "but that's really good news for inflation."It's not just workers pounding the pavements who lose from low inflation. Elderly people living on interest income also suffer. Interest rates on certificates of deposit sank from 8% to 6% in the last year. And anybody who bought real estate expecting higher or even stable prices has had a rude shock.
But lower interest rates will spur all types of capital investment. And many debt-laden companies will see immediate gains. At New York-based Avon Products Inc., for example, the rate on 70% of its short-term debt floats, so any general drop in rates is an immediate boon.
The full benefits of lower inflation won't come right away. It'll take "six to nine months of recovery without inflation," says Ratajzcak, to convince people that low inflation is here to stay. Then, the capital markets should catch on, lowering interest rates. And that's why the important headway that's been made on service-sector inflation, if it turns out to be more than fleeting, offers real promise of brighter times to come.