Is Easing Inflation A Gleam In The Gloom?

Every dark cloud has a silver lining. For recessions, it usually takes the form of slowing inflation. This time, however, price increases remain stubbornly high even after 10 months of declining economic activity. But signs of improvement are appearing, and they will become more widespread as the year progresses.

That's because the economic fundamentals are in place to ensure lower inflation this year. Smaller wage hikes, improved productivity, and lower borrowing costs are giving businesses some breathing room on the cost side. And weak industrial output means more capacity is going unused. With demand still soft, companies are foregoing price hikes in order to attract new customers and start their assembly lines rolling again.

Moreover, improvement in inflation usually lags behind a turnaround in economic growth. So price gains should continue to slow even after the recovery starts to take hold later this year. The progress on the inflation front is good news for the Federal Reserve. Smaller price hikes allow the central bank to concentrate on ending the recession.

SLOW AND STEADY WINS THE PRICE RACE The latest price reports confirm that inflation is starting to moderate, slowly but surely. Both consumer prices and producer prices of finished goods rose a mild 0.2% in April, after declines in March. Falling fuel costs are leading the inflation slowdown. But sagging demand, inventory problems, and idle industrial capacity are taming price rises for other goods and services.

Excluding food and energy, the consumer price index increased by only 0.2% in April and 0.1% in March. Since January, this core rate of inflation has risen at an annual rate of just 4.4%, down considerably from the 5.9% clip in the three months before that. Over the past 12 months, the core rate is up 5.1%, which is still high but a significant improvement over the 5.7% pace posted during January (chart).

One promising development is that the slowdown in the CPI is taking place in both services and goods. Goods prices have been well-behaved for more than a year, as sluggish spending on everything from clothing to furniture has kept prices from rising by very much.

But now, weaker demand for services is having some effect on inflation there. Prices of nonenergy services rose at a 4.1% annual rate in the three months ended in April, down from the 6.2% advance in the three months before that and the 6.4% pace in the three months ended in July when the recession

began. The slowdown in service costs is mostly in the housing sector, which makes up about one-half of the CPI for services.

The inflation rates for some goods and services remain at remarkably high levels even this far into recession. But the acceleration in prices for such nonessential items as entertainment and toiletries seems unlikely to continue, because income growth remains low, leaving households with less discretionary cash. Moreover, consumers still show little eagerness to go out and spend. SHOPPERS ARE STILL JUST BROWSING That was the case in April, when retail sales edged down by 0.1%, to $ 151.5 billion. The decline suggested that the recession continued into this quarter. But along with the release of the April data, the Commerce Dept. reported a revision in the March numbers to show a 0.4% gain in sales for that month. Previously, March store receipts were estimated to have dropped by 0.8%.

Such a large revision is not unusual, but the gain in March caused some to wonder if the recovery had fallen into place by the end of the last quarter. Indeed, bond traders seemed to dislike the sales report because an early recovery would wipe out the progress being made in inflation. The jitters in the bond markets sent shock waves through Wall Street. The stock and bond markets weakened after the release of the retail data on Apr. 14.

But after adjusting for price changes, retail sales remain on a downward trend (chart). In April, real store purchases were still about 2% below their levels of a year ago.

In addition, the early signs for May shopping aren't spectacular. New domestically made cars sold at an annual rate of 5.4 million during the first 10 days of the month. That's worse than the awful 5.5 million pace for all of April, which was the sorriest monthly sales performance in 8 1/2 years.

Clearly, the retail sector has a way to go before rebounding. And only expanded spending by consumers can help retailers out of their hole. Until then, stores will probably continue to use discounts to draw shoppers in. That means smaller price increases in coming months.

The recession's impact is not just on consumer inflation, of course. It also means that manufacturers and distributors cannot mark up prices at the wholesale level. And the slowdown in inflation at the production stage is much more stunning than at the consumer level.

PRODUCER PRICE HIKES ARE SLOWING Indeed, the small gain in finished-goods prices in April followed declines in each of the previous four months, mostly caused by falling fuel costs. As with consumer prices, the April reading for producer inflation would have been more modest except for a record runup in the prices of fruits and vegetables. That sharp increase is unlikely to be repeated in coming months. Excluding food and energy, producer prices rose by 0.2% in April.

Inflation at the producer level, excluding the gyrations of food and energy costs, hit a six-year high of 4.7% back in mid-1989, right after the industrial sector began to slide. Since then, price hikes have become quite meager. Prices are up just 3.7% in the past 12 months.

Even as businesses are finding it hard to pass along price rises, manufacturers themselves are benefiting from a slowdown in cost increases for the materials they use to make consumer and business goods. Prices of industrial supplies, excluding food and energy, have fallen for five months in a row, including a 0.2% downtick in April. The costs of raw materials are also dropping.

FACTORIES BRING OUT THE MOTHBALLS The sorry state of manufacturing ensures that wholesale inflation will grow more subdued. Industrial output managed a small 0.1% gain in April, but the revised March data showed that output in that month dropped by 0.6%, not the 0.3% fall initially reported. Factory output rose 0.2% in April, after falling 0.8% in March.

Auto makers led the April gain in output. Excluding cars, production declined by 0.2%. However, car production in April was some 10% below its pace of a year ago. Car dealers are being careful about ordering new cars, and that's causing some buildup of inventories at auto factories. Excess stockpiles plus the sickly pace of car sales mean that the auto industry isn't going to lead this economy out of recession.

With output so weak, many companies are mothballing more of their equipment and locking their factory doors. The capacity utilization rate for all industry dropped to 78.3% in April, from 78.5% in March. Manufacturers used only 77.1% of capacity, down from 77.2%.

Operating rates are now beneath their lows of the 1986 industrial slump and stand at their weakest since the 1981-82 recession. As long as demand remains comatose, operating rates will slip further. That means the small capital-spending rebound expected in the second half won't happen. Companies simply will have too much capacity already on hand.

Businesses may have too many goods on hand as well. True, inventories at factories, wholesalers, and retailers have been cut since the recession began. But because sales have declined even more steeply, companies are holding bigger stockpiles than they probably want.

In March, business inventories dropped 0.8%, led by a 1.4% decline in retail stockpiles. But business sales fell by a larger 1%. In the past year, inventories have risen by just 1.3%. But sales have fallen a sharp 3.4% (chart). An overhang of inventories is especially acute at the factory and wholesale levels.

The buildup of stockpiles opens the way for further price cuts. Companies, eager to clear their warehouses, are likely to hang out sale signs. That means the inflation rate should continue to slow, giving the dark recession clouds a bright rim.

Before it's here, it's on the Bloomberg Terminal.