The Lesson For Wall Street: Consumers Won't Put Up With Higher Prices

Let's face it: The August producer price index was downright ugly. Its 0.6% jump scared the pants off Wall Street because it seemed to confirm the markets' worst inflation fears. Stocks, bonds, and the greenback all nose-dived. The core PPI, excluding energy and food, also rose an unexpectedly steep 0.4%, raising fears that August's consumer price index would echo the bad news.

The joke was on those who panicked. The CPI came in as pleasant-looking as ever, with both the total and the core indexes rising a moderate 0.3%. The lesson here is that, despite evidence of budding price pressures early in the distribution chain, consumers are only grudgingly--if at all--accepting any markups on the products they buy.

A key reason why this trend will remain in place is the Federal Reserve's hiking of interest rates. In the wake of rate hikes, the refinancing boom is now a bust, and people with adjustable-rate mortgages must cope with a new drain on their cash flow. As a result, consumers have scaled back their shopping--a slowdown that will carry over to industrial production and job growth.

The cooler pace of demand makes it difficult for retailers to push through higher prices. But for now, the need for heavy markups is muted. Businesses continue to invest heavily in new productivity-enhancing equipment. And wage gains remain modest. Both trends limit the growth in labor costs, still about three-quarters of total business expenses.

Although inflation has probably hit its low point for this business cycle, any upturn will come gradually. Consumer inflation is on track to end the year at about 3%. And given the restraining forces, an acceleration

to about 31/2% in 1995 seems about as much as can be


The consumer price index showed that price pressures at the retail level are no worse than spotty. Yearly CPI inflation in August stood at only 2.9%, the same as the core index (chart). The core rate has been essentially steady since January.

On closer inspection, even producer prices appeared less frightening. Wholesale prices for energy jumped 1.7%, pushed up by a 6.8% spike in gasoline prices. But fuel may well be cheaper in coming months, reflecting the $3-per-barrel drop in crude oil prices during August. Other hikes that will not be repeated: coffee prices, which jumped 12%, and beef, up 6.9%

The only worrisome sign at the wholesale level was a continued acceleration in the prices of unfinished intermediate goods, such as lumber, industrial chemicals, and paperboard. However, prices of crude materials fell 0.4% in August, suggesting that earlier pressures on materials prices may be starting to ease. Of course, it's not a sure thing that the speedup in intermediate products will even reach finished goods, let alone retail prices.

Even the watchful Fed sees no signs of carrythrough. In its Sept. 14 report on economic activity across the nation, the Fed said that "economic activity continued to expand through the summer," although some "stronger areas saw growth plateau." More significantly, the central bank noted that even with higher industrial materials prices, stiff competition continued to restrain price increases for finished goods.

In fact, producer prices aren't rising as fast as consumer goods prices, so retailers' profit margins are not being squeezed. Even if margins do start to get pinched, picky consumers may force many retailers to eat the loss.

Consumer prices were well-behaved across the board in August. Excluding energy and food, service prices rose 0.4%. But the yearly pace, at 3.5%, remains in a downtrend. Since May, service inflation has held close to a 10-year low. Core goods prices actually fell 0.1% in August, with the yearly rate of rise at 1.5%. Clothing prices dropped 1%, after a 0.4% dip in July. Most likely, stores cut prices to move out summer inventories before the new fall lines arrived.

Retailers were able to clear some shelf space in August. Retail sales rose 0.8% after no change in July. Receipts in all the major durable-goods categories rebounded in August, after a dismal July. Sales of nondurable goods continued barely to match the pace of inflation.

Healthy sales increases at clothing and department stores suggest a good back-to-school season. However, that does not negate the slowdown (chart). So far in the third quarter, inflation-adjusted retail sales are up a mere 1.2% at an annual rate.

Retailers who are struggling can blame higher interest rates for that weak showing. Thanks to the Fed, consumers can no longer easily tap into two major sources of cash--mortgage refinancings and credit cards--that propelled spending in 1993 and early 1994. And with those wells dry, shoppers will remain stingy in the second half.

According to the Mortgage Bankers Assn., loan applications to refinance a mortgage have dropped to one-tenth of their pace in February, when fixed mortgage rates hovered just over 7% (chart). In addition, the rate on a one-year Treasury bill, a common basis for adjustable mortgages, has risen 2.1 percentage points in the past year. If homeowners made no extra payments to the principal, that increase would add $120 to the monthly payments of a $100,000 adjustable mortgage.

At the same time, costlier finance charges--especially for credit cards tied to banks' prime lending rates--have shoppers thinking twice about using plastic. Witness the $5.6 billion gain in installment credit in July, half the $11 billion pace in the four preceding months.

The lack of refis and credit leaves disposable income as the key support to consumer spending. But here again, the Fed's tightening hurts. Real disposable income tracks job growth. And with demand slowing, fewer workers will be hired, suggesting incomes will grow only modestly into 1995.

The Fed must focus primarily on reining in consumers because it will have less influence on other sources of output growth in coming quarters. U.S. exports, for instance, will gather strength from economic growth overseas. And businesses are deciding to buy capital equipment based on what it adds to efficiency rather than on borrowing costs.

Indeed, Corporate America is boosting its outlays for new plants and equipment in the pursuit of productivity--the economy's St. George that may well slay this cycle's inflation dragon. The Commerce Dept.'s summer survey on capital outlays shows that companies are set to increase their budgets by 8.8% in 1994. That's better than the 7.3% rise in 1993, and faster than the 8.3% gain projected in the spring survey.

Both factories and service companies are set to spend more in 1994 than in 1993 (chart). Not surprisingly, manufacturers in such industries as steel, electrical machinery, and plastics that are planning double-digit increases to their capital investments are the same industries where operating rates are above 87%. Manufacturing as a whole will spend 7.3% more this year.

Nonmanufacturers are pumping up their budgets by a hefty 9.5%. The biggest increase will be the 12.5% in commercial and other services, which includes wholesale and retail trade, finance, business services, and communications. Already, second-quarter spending by retailers was 19.3% above a year ago, and finance budgets were 15.7% bigger.

All this investment will go toward improving the efficiency of service companies, where productivity gains have lagged the advances made at factories. Clearly, companies must hold down their unit labor costs to keep the price indexes appealing to the wary eyes of inflation-fearing investors who are quick to see flaws in the price data even during this most pleasing time of low inflation.

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