U.S.: The Coming Battle Between Profits And Prices

Pricing power is rising, but so are costs -- and that will soon squeeze margins

The latest signs of a stronger economy, as well as twin surprises in the October price data, have heightened worries about an inflation threat, if not right away, then sometime in 2005. But the most important trend in the realm of pricing is the developing tug of war between prices and profits. Companies are dealing with heightened cost pressures, whether on the labor front or from higher commodity prices. And solid demand and a weaker dollar mean U.S. companies have gained some ability to pass along these rising expenses. But it is still uncertain how much of the bigger tab companies will be able to pass through to consumers, and how sharply the costs will eat into profit margins.

What makes the cost squeeze a threat to the profit outlook is the ratcheting down of productivity growth. A slowdown in the growth of output per hour is a normal trend at this stage of an expansion, though the easing may be more acute this time around since U.S. businesses had been logging efficiency gains averaging 4.2% in the first three years of recovery. That's a rate well above productivity's long-run growth trend.

Where Inflation Is Warming Up
But in 2005, businesses will not be able to rely on higher productivity to cover the increases in labor costs coming as the job markets tighten. Already, hourly compensation has risen faster than productivity in each of the past two quarters, and that pattern is likely to continue. As a result, unit labor costs will keep rising, instead of shrinking, as they did from early 2002 to the first quarter of 2004.

Businesses will face some hard choices as a result, and their decisions will go a long way in determining the outlook for both economic growth and inflation next year: If prices don't keep up with costs, then profit margins will get squeezed by more than now forecasted. That puts capital spending and the stock market at risk. But if prices do keep up, then overall inflation could pick up more than expected, creating headaches for both bondholders and policymakers at the Federal Reserve.

BESIDES PRODUCTIVITY'S DOWNSHIFT, the biggest change in the price outlook for 2005, compared with 2004, is the different global environment. From its peak in February, 2002, until this October, the dollar has fallen by 13% on a broad trade-weighted basis. Although the fall has not been across the board against the U.S.'s major trading partners (the euro and yen have strengthened far more than the currencies of most emerging nations), the nearly three-year decline in the dollar has finally caused some inflation in imported goods.

For all nonoil imports, the swing has been significant. In February, 2002, these prices were falling 5.1% from the previous year. In October, 2004, they were up 2.7% from a year ago. Much of that acceleration came from raw materials, even outside of energy, but a shift was clear for imported consumer goods as well. Prices there fell 1.3% in the year ended in February, 2002. By last month they were rising 0.5%.

That swing has given U.S. manufacturers the opening they needed to mark up their own price lists. Producer prices of core consumer goods, which exclude food and energy, have risen 1.7% over the past year, a sharp change from the price declines posted in 2002 and early 2003.

Labor Costs Catch Up With Prices
On the retail level, prices of consumer goods are finally beginning to emerge from outright deflation. From the start of 2002 until September, 2004, core consumer goods prices were falling, dropping on a yearly basis by as much as 2.6% in November, 2003. But the declines began to lessen in 2004. And in October, core consumer goods prices posted a small 0.1% gain from a year ago.

BEAR IN MIND, the recent spate of deflation was an anomaly caused mainly by the combination of the dollar's past surge and a global slump in demand, not to mention China's increased penetration into U.S. markets. In the first two years of this recovery, the drop in goods prices offset much of the runup in service inflation, resulting in a slowdown in overall core inflation.

Those global forces haven't gone away, but the re-emergence of goods inflation signifies a return to more normal conditions in goods pricing. That trend should continue, and it means that goods deflation is no longer balancing out service inflation. Since the end of last year, the shift from price cuts to hikes in goods has accounted for nearly all of the 0.9 percentage-point increase in the annual pace of overall core inflation, even as service inflation remained nearly stable.

The pickup in inflation all but assures that the Fed will continue to lift interest rates at a steady pace next year. Policymakers have doubled the federal funds rates since June, to 2% currently. But because inflation is also higher, the real funds rate is still essentially zero. That means policy is far more accommodating to growth and inflation than the Fed wants.

WHAT'S IMPORTANT TO NOTE is that the uptick in core consumer inflation this year has not been nearly as big as the rise in core prices in the earlier stages of processing. For example, prices for unfinished intermediate goods have shot up by 7.8% from a year ago, but prices for finished goods are up only 1.8%. Businesses are absorbing some of that acceleration.

And even as many businesses raise their prices, they also face bigger bills for labor. Job growth in the U.S. should continue to increase in 2005, resulting in tighter labor markets and higher payroll costs at a time when productivity is slowing. Already in the third quarter, nonfarm productivity was up at an annual rate of just 1.9% from the second quarter when it grew a more impressive 3.9%. Last quarter's gain barely offset half of the 3.6% rise in compensation, leading to a 1.6% jump in unit labor costs. That increase was equal to the 1.6% rise in prices.

In 2005, expect to see more businesses trying to bridge the gap between the prices they pay for labor and materials and the prices they receive for their wares. That will most likely result in somewhat higher core inflation. However, intense global competition has not gone away, and it will remain the great enforcer for U.S. pricing. Over the past year, the dollar has actually risen against the currencies of countries that make up 40% of the U.S.'s trade volume -- mainly Asian and Latin American nations.

Of course, some companies will be more successful at raising their prices to meet their costs. And others will refocus their productivity efforts. But most will probably have to suffer some squeeze in their profit margins. Shareholders will be unhappy, but for the economy as a whole, the strains won't be that damaging. As even Fed Chairman Alan Greenspan has pointed out, margins now are sufficiently high that most corporations can absorb some of their higher costs.

So how will the tug of war between prices and profits play out in 2005? Look for some combination of rising inflation and a downward pull on earnings. Although many businesses will enjoy a shade more pricing power, it will probably not be sufficient to overcome all of the cost pressures companies will face.

By James C. Cooper & Kathleen Madigan

Before it's here, it's on the Bloomberg Terminal.