Prices Just Keep Plunging

Fears of deflation are growing as a profit squeeze prompts more cuts

The economy is growing, and consumers, who still seem to have plenty of cash to spend, are turning out in droves to buy houses, autos, and lots, lots more. So are stores and goods makers jacking up prices? Hardly. In these topsy-turvey times, the opposite is more often the case. One recent example: On Oct. 4, Danbury (Conn.)'s Ethan Allen Interiors Inc. slashed retail prices on entry-level furniture lines by up to 20%. "We thought it was a good time to grab market share," says CEO M. Farooq Kathwari.

A smart business move? Could be. A break for consumers? Certainly. But one that, taken with all the similar decisions being made by businesses across the economic spectrum, has troubling implications. Huge swaths of the economy are facing ever-weakening pricing power; indeed, in many sectors, prices are tumbling outright. Capital goods, apparel, furniture, long-distance telephone services, automobiles, lodging, appliances, online delivery charges, and airfares are all falling--in some cases, at double-digit rates. Says Richard A. Galanti, CFO at discount retailer Costco Wholesale Corp. (COST ): "Deflation is across the board."

Fortunately, that's a bit of an exaggeration. The real problem for most companies today is disinflation, or a slowdown in the rate of price hikes. For consumers, prices rose a mere 1.8% from August, 2001, to August, 2002. That's roughly half the rate in 2000, when retail inflation was 3.4%. And overall, prices for consumers and businesses combined are increasing at the slowest pace in almost 50 years, according to the Commerce Dept.

In inflation-fighting times, that would be hailed as good news. No longer. The lack of pricing power is cramping business and could end up damaging the entire economy. Profits are being squeezed, forcing employers to cut costs and people wherever they can. That means less capital investment or spending on research and development and higher real borrowing costs. It also means more outsourcing to low-cost sites outside the U.S. This penny-pinching could slow the recovery and ultimately lead to a deflationary spiral--a condition the U.S. hasn't seen since the 1930s.

Of course, some prices have been falling for years. That's especially true for computers, consumer electronics, and industrial goods such as steel. And price wars typically break out during recessions as vendors battle for consumers. But something new and troubling may be happening today. Excess capacity is growing around the world, particularly as products from low-wage China appear in more and more sectors. Meantime, demand in many industries is fizzling. In addition, the recent surge in productivity is encouraging the efficient to slash prices, forcing rivals to match their discounts or lose share.

What's most worrisome, many economists say, is that price-cutting is now spreading from manufacturing to the vastly bigger service sector. Says Morgan Stanley chief economist Stephen S. Roach: "The U.S. is in the throes of the most disinflationary pricing cycle ever experienced in services."

Federal Reserve Board Chairman Alan Greenspan and others at the central bank are taking notice. While the Fed has long sought price stability, its policymakers are concerned that the spreading price malaise is symptomatic of the general weakness in the recovery. And they recognize the dangers to the economy should disinflation turn into an unstoppable downward price spiral. Deflation "wasn't even on radar screens in past recoveries," said Richmond Federal Reserve President J. Alfred Broaddus Jr. in an Oct. 2 speech. Now, "it is in the range of plausible risks."

Of course, the strongest and most efficient companies are handling pricing pressures with relative ease. Southwest Airlines Co. (LUV ) can still make money with its discount fares even as other carriers lose record sums. Why? Its expenses are 29% below the industry average, according to an Oct. 9 study by Unisys R2A Transportation Management Consultants. "We're prepared for a weak environment like this," says Southwest Airlines CFO Gary C. Kelly.

Others are rolling out must-have offerings that carry higher markups. As prices drop in low-end appliances, General Electric Co. (GE ) is pushing high-end refrigerators that list for $2,099 to tap into the high-margin luxury-goods market. PepsiCo Inc. (PEP ) is pursuing a margin-boosting strategy with bite-size Go Snacks chips, which have become big hits despite higher prices through convenient canister packaging.

But many more companies are using slash-and-burn tactics, such as chopping budgets and payrolls. US Airways Group Inc. (U ) announced on Oct. 8 the furlough of 642 people. Days earlier, Northwest Airlines Corp. (NWAC ) and Delta Air Lines Inc. (DAL ) said they'll dismiss 3,100 flight attendants. Still, big carriers could lose as much as $8 billion in 2002.

A glut in goods and services is why many businesses lack the power to nudge prices higher. To be sure, many companies have cut back on capacity, shutting factories and offices and exiting markets. Yet the cuts haven't been enough, given current demand levels. Excess capacity exists in everything from telecom and aluminum smelting to banking and retail stores. And the rise of production in extremely low-cost countries, especially China, is exacerbating price pressures in an array of industries.

As disinflation spreads, it is clearly making its way toward services. Lisa Smith, a director at legal-management consultant Hildebrandt Inc., estimates that revenues at some top law firms could slump 10% this year as clients balk at paying quoted rates. "Clients are looking at bills and saying: `This is too high,"' says Smith.

Other service industries are reacting to excess capacity and weak demand with savage price wars, further depressing prices. In telecom, the long-distance carriers and the so-called Baby Bells all built competing networks over the past several years, anticipating ever-growing demand. That miscalculation has sent many into bankruptcy and is causing prices to tumble as the survivors square off for battle. SBC Communications Inc. (SBC ) has shaved 33% off its rates in Michigan since February, largely because of recent offerings from AT&T (T ) and MCI WorldCom. To pay for that, SBC also announced that it will slash 11,000 jobs.

Sales of PCs and other high-tech gear are also struggling despite PC prices that are over 20% lower than a year ago. "Almost no price is low enough to encourage information-technology buyers," says Robert B. Austrian, an IT analyst at Banc of America Securities LLC. "There's a virtual buyers' strike."

That's not true across the board, of course. Health-care prices are rising by double digits, while car- and home-insurance premiums are rising at jaw-dropping rates as insurers try to recoup outlays from September 11. And companies with unique products or monopolies also can raise prices almost at will. Microsoft Corp. (MSFT ) has just launched a new licensing program that ups prices for at least 20% of its business customers.

But in far too many industries, too much supply chasing too little demand means weak pricing, and an almost inevitable shakeout ahead. "We have too many businesses," says Northern Trust Corp. chief economist Paul Kasriel, "and they can't all make it." Consumers who hang on to their jobs will benefit. But the looming shakeout will be a tough trade-off in the battle against inflation.

By Michael Arndt in Chicago, with Charles Haddad in Atlanta, Rich Miller in Washington, Jim Kerstetter in San Mateo, and bureau reports

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