Why Price Pressures Aren't So Pressing Anymore

Face it. Inflation has changed. And with the economic outlook and monetary policy still focused on the trade-off between inflation and growth, it's time to take a closer look at why price pressures in the 1990s are different. What shows up are powerful structural shifts in competition, consumer behavior, and productivity that signal a new framework on which to hang inflation's hat.

Certainly, inflation has been remarkably tame during this expansion, which is now almost four years old. Through the month of January, annual consumer inflation was only 2.8%, and the core rate, which excludes the often erratic pattern of energy and food prices, stood at a gentle 2.9% (chart).

Inflation just isn't supposed to be so well-behaved at this point in the business cycle. Historically, core inflation would have already hit bottom and started its rise to a new peak. On average, the core inflation rate after 46 months of expansion has been about even with its pace at the end of the previous recession. Core inflation in January, however, was about half of its 5.3% pace at the end of the 1990-91 downturn.

Certainly, the traditional forces that have enabled businesses to hike prices in the past are starting to appear. Tighter labor markets are leading to faster wage growth. Higher capacity use raises the risks of production bottlenecks. And stronger economic growth around the globe has pushed up commodity prices.

THESE CYCLICAL FORCES are why inflation is expected to creep higher this year and next. Indeed, the January consumer price index rose 0.3% from December, while the core index jumped 0.4%. That performance was worse than expected. It was fueled by a 0.7% jump in apparel prices after six months of decline, and a 0.6% increase in transportation costs, reflecting an upturn in airfares and another large gain in auto finance charges. Housing costs, up 0.4% in January, also rose faster, partly because of the 10.3% rise in postage fees.

But other powerful structural forces are overwhelming the cyclical pressures. This new inflation paradigm means prices in this upturn will peak at a much lower rate than their high of 5.5% in the previous expansion.

The new look of inflation can be traced to changes in how the U.S. does business and shops, and how it competes with foreign rivals. Most important is Corporate America's push to lift productivity. Higher productivity levels have restrained the growth in unit-labor costs and actually lowered them in the manufacturing sector. Better output per hour worked at the factory also means that every rise in capacity use yields an even greater addition to output, diminishing the risks of shortages and bottlenecks.

Indeed, better efficiency is why increased production and rising operating rates have not yet touched off the usual wage-price spiral. Also, the Federal Reserve's past interest-rate hikes may be starting to slow industrial activity. Industrial output rose 0.4% in January after gains twice as large in November and December. In manufacturing, output rose just 0.3%, after the 1% increases in the two previous months.

Some of that slowdown might have been caused by an excessive buildup of inventories at the end of last year. However, the government's inventory data through December suggest that stock levels are in line with sales. Business inventories rose 0.2% while sales jumped 1.3%.

But despite the smaller gain in output, operating rates for all industry rose to a 15-year high in January of 85.5%. Rates in both primary and advanced processing have surged (chart). But because companies are more efficient now, shortages of goods have been rare, and customers have not had to accept higher prices to get supplies delivered.

LOWER UNIT-LABOR COSTS have also given businesses some room to absorb rising commodity prices without too much damage to the bottom line. That's important because stiff competition from both domestic and foreign rivals has prevented most companies from passing along the higher cost of raw materials.

In its January producer price index report, the Labor Dept. states that prices for finished goods rose 0.3% last month, but the figure dips to just 0.2% when food and energy are excluded. Over the past year, the core PPI is up a mere 1.5%. That's quite a contrast to the 17.4% jump in raw-material prices and the 6% price hike found in intermediate goods that have undergone some processing.

Businesses would have less trouble passing along price hikes if not for the striking shift in consumer spending patterns. In the austere '90s, consumers are simply unwilling to accept price hikes. This tightfisted behavior was fed by the same corporate downsizing that cut labor costs.

Moreover, there are many more demands on household incomes today--from contributions to pension plans to higher property taxes and savings for children's college expenses. And the budget squeeze will grow tighter this year as past Fed tightening boosts the cost of carrying credit-card balances and the monthly payments for adjustable-rate mortgages.

THE NEW AUSTERITY might not have gained a hold in the consumer psyche, though, if retailing itself had not changed. Consumers now can feed their bargain-hunting cravings at a vastly greater number of discounters and warehouse outlets than they could in the 1980s. Ten years ago, there were 755 Wal-Mart Stores and Sam's Wholesale Clubs. Today, almost 2,600 such stores dot the retail landscape.

In fact, many retailers cited discounting as a reason for the lackluster pace of sales. Retail sales rose 0.2% in both December and January (chart). Merchants, especially department and apparel stores, had to cut prices to move goods that just didn't make it as holiday gifts.

Past Fed tightenings also played a role in keeping shoppers at home. Sales in January were weak for interest-sensitive items. Car sales fell 0.6% last month, and furniture buying dropped 0.7%. This sluggishness should continue throughout 1995 as the seven rate hikes since February, 1994, work their way through the economy. As hiring and income growth slow this year, consumers will be even more resistant to price hikes.

But do the structural changes mean that the Fed's yearlong inflation fight has been wrong? Even Fed Chairman Alan Greenspan noted in late January that the CPI overstated actual inflation from 0.5% to 1.5%. He said the upward bias meant that the U.S. is near price stability, but he added: "We are not there yet."

Indeed, the Fed is concerned not only with the level of inflation but with its direction as well. That is why policymakers will keep this economy on a short leash. Their strategy will work to keep the cyclical forces of tight labor markets and goods shortages at bay. The new inflation paradigm will simply enhance the Fed's work and enable the U.S. to enjoy the best inflation decade since the 1960s.