Let the Markups Begin

Over the past few years, many companies have seen profits shrivel, thanks in no small part to their inability to raise prices. Competition from cheap imports, diminished demand in a weak economy, and excess production capacity made it tough to make a buck.

But now, thanks to a weak dollar and slow improvement in the economy, pricing power is making a comeback. Yes, Federal Reserve Board Chairman Alan Greenspan has recently raised concerns about deflation, or falling prices. Yet the latest producer-price-index data from the Labor Dept. show that prices for raw materials, excluding food and energy, rose 15.1% from a year ago. Instead of absorbing higher costs, businesses are gaining some ability to pass them along. Intermediate-goods prices rose 2.6% from a year ago, far better than the 1.7% yearly fall posted last March. Consumers typically see prices rising 12 to 18 months after raw-materials prices climb, pointing to wider pricing power in early 2004. Already, in the first quarter, prices that companies charge rose 1.2% from a year earlier (chart).

To be sure, some service sectors such as health care and education have been able to raise prices throughout the downturn. But for heavy industry, the ability to finally pass on higher materials costs has been a boon. Dow Chemical (DOW ) Co. reported a first-quarter profit of $76 million, despite a $1.2 billion jump in energy and feedstock costs. How? By pushing through a 38% increase for its plastics products and a 4% hike for seeds and fertilizers. It's a big change from the last time energy prices spiked in early 2001, says Chief Financial Officer J. Pedro Reinhard. All those increases won't stick, but in an effort to make up for earlier price cuts and higher costs, Dow says it expects to keep enough of them to see an average 14% price increase in 2003. Likewise, at the start of the year, Caterpillar (CAT ) Inc. bumped up prices by 2% to 2.5%, the biggest increase in three years.

What changed? For one thing, U.S. businesses are getting a shot of help from a weaker dollar. Companies that face stiff competition at home from foreign producers have a chance to mark up prices because imports are becoming more expensive. Excluding petroleum, import prices climbed an annualized 4% in the first quarter, after falling 2.4% in 2002. Over the past several years, a "great deal of the downward pressure on goods prices" was due to the strong dollar, says Ian Shepherdson, chief U.S. economist at High Frequency Economics.

Meanwhile, after years of cost-cutting, businesses have put the brakes on expanding production capacity. Excluding tech and telecom equipment, the Federal Reserve said that in March, factory capacity grew only 0.1% from a year ago -- far below the 2.2% average annual pace from 1995 through 2002. Some industries -- paper, apparel and textile, metals, and chemicals -- have done a good job of scaling back on capacity, says Richard Berner, chief U.S. economist at Morgan Stanley (MWD ) But, he adds, "there's clearly more work to do in motor vehicles, technology, telecom equipment, machinery, and several service industries."

The economy should also pick up steam, aided by fiscal stimulus. Shepherdson sees expansion of 3% in 2003, but he isn't ruling out a strong second half that produces 4% annual growth. If that happens, excess capacity would quickly disappear. Then, a whole range of industries could regain the upper hand in pricing.

By James Mehring in New York, with Michael Arndt in Chicago

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