Is Inflation Down For The Count?

Five, four, three, two, Not too long ago, a 5% inflation rate seemed set in stone. When Americans bargained for pay raises or haggled over home prices, they simply assumed that inflation would continue at a fast clip. That changed with the recession of 1990-91, which pushed over-all price increases down to a soothing 3%.

Now, to practrically everyone's suprise, inflation is about to downshift once again. With high unemployment, slowing medical inflation, and price-cutting in consumer products, 3% is no longer the floor. "I'm looking for 2% inflation by the end of the year," says Edward E. Yardeni, chief economist at C. J. Lawrence, a New York investment bank.

And because of measurement problems, event that 2%, low as it sounds, may overstate the actual inflation rate by a wide margin. The governments' consumer price index does not include home mortgage rates or home-computer prices, both of which have plummeted in the past year. And the CPI doesn't fully account for the growing sales of discount chains. This hidden disinflation means that for the first time in recent memory, the U.S. may be close to zero inflation.

To be sure, there are skeptics who see signs that the inflation rate will soon be bouncing back up. They point to the recent 8% rise in the price of gold, often considered to be a harbinger of inflation. And they worry that as the economy recovers, companies will try to make up for lost time and boost prices. Clinton's tax hikes, if passed, could also eventually give inflation a big jolt.

But what he skeptics miss is that the forces of disinflation have been unleashed thoughout the industrial world as global competition takes hold. France and Britain are registering inflation at about 2%. So is Canada. And in Japan, the rate is a stunning 1.2%.

As international competition heats up, it will be hard for U.S. companies to raise either wages or prices, despite economic recovery. Prices for industrial commodities, such as metals and lumber, are falling again after a brief rebound earlier this year. And productivity-seeking companies continue to cut costs wherever possible, keeping the lid on inflation. For example, General Electric Co.'s appliance unit is demanding annual 10% cost cuts of its suppliers.

And low-inflation religion finally has spread to sectors of the economy that seemed insulated from competition for years. Take medical-care inflation, which hit a peak of 9.6% in 1990, but now is running at an annual rate of less than 6%--and falling fast. "We've had some pretty strong pressures on prices for 18 months, and every quarter there's a new reason for it," says Robert J. Gallagher, chief financial officer at Acuson Corp., a California maker of big-ticket ultrasound equipment. "Hospital adminstratotrs are taking more time and care with buying decisions." With the new focus on cost containment, medical inflation could drop as low as 3% by the end of 1994, says Yardeni. That could chop a half-point from the overall inflation rate, and perhaps more.

SMOKE OUT. Persistent inflation pressures are also abating in the consumer-goods sector of the economy, as Americans tighten up on their wallets. Since the end of 1989, per capita consumption of consumer nondurables, such as food and tobacco, is down 1.7%, even while spending on consumer durables and services rose 3%. That has forced consumer-goods companies to hold down, or even roll back, price increases.

The new price wars in the cigarette industry could by themselves help drive inflation down to new lows. Prices of tobacco products have been rising at a 10% annual clip since 1988. But recently R. J. Reynolds Tobacco Co. announced plans to slash the prices of its Winston and Camel brands, following the lead of Philip Morris Cos. Many analysts now expect cigarette prices to actually drop by 10% over the next year. Since cigarettes make up almost 2% of the CPI--a larger share than dairy products or men's clothing--that could slice 0.4 percentage points off inflation over the next year.

Food prices should be flat, too, after chalking up several years ef 5% increases at the end of the 1980s. "If there's any inflation in the food-at-home industry, I can't see it," says John McMillin, an analyst at Prudential Securities Corp. "The competition is very intense." Indeed, makers of brand-name food products are being forced to cut prices rather than lose market share.

CHAIN LINKS. All told, these factor could pull inflation down by a percentage point or more over the next year. But there's more good news on the price front that doesn't show up in the official CPI numbers--especially in the cost of home ownership which accounts for 20% of the CPI. Since 1983, the Bureau of Labor Statistics has calculated the cost of home ownership by looking at the cost of renting comparable houses. In normal times, that works fine. But when interest rates plunge, mortgage payments fall much faster than rents do. So while the BLS figured home-ownership costs to rise by 3% last year, the actual amount paid by most homeowners dropped by 10% or so, cutting as much as 2 percentage points from the overall inflation rate.

But there's another source of hidden inflation. The market basket of goods in the CPI is based on 10-year-old buying patterns. That means, for example, the CPI does not completely reflect the soaring popularity of discount chains that offer lower-than-retail prices for food and other items. According to the BLS, this could cut 0.2 to 0.3 percentage points from food inflation, and perhaps 0.1 points from the overall inflation rate

And home computers, one of the fastest-growing spending categories, are almost completely ignored by the CPI. That means the sharp decline in computer prices barely is reflected in the government's inflation numbers. And this distortion in the inflation rate will only get bigger as home computers and other new types of home electronics become increasingly popular.

Despite the strong case for continued indisinflation, the conventional outlook calls for a 3% inflation rate over the next year. But it will soon become apparent that such forecast are based more on past fears than on present realities.

      HOUSING - The CPI leaves out the impact of plunging mortgage rates on home 
      ownership costs. Instead of rising by 3%, as the government reported, these 
      costs in fact fell by 10%.
      DISCOUNTING - Despite the growth of low-price warehouse stores, the PCI gives 
      too much weight to full-price retailers. This means inflation for food, 
      apparel, and other consumer items is overstated.
      HOME COMPUTERS - The CPI is based on spending patterns from 1982-84, when home 
      computers were stil scarce. So the CPI doesn't pick up the consumer savings 
      from falling computer prices.
Before it's here, it's on the Bloomberg Terminal.