U.S.: Signs That Inflation Is Losing Its Fangs
As 2005 began, the economy faced the weakest dollar in more than seven years, oil prices near $50 a barrel, and forecasts of slower productivity growth and rising unit labor costs. In the past, that combination -- coming at a time of solid economic growth -- was a recipe for serious inflation worries and strong policy action. In fact, the latest consumer price report showed that inflation rose to 3.3% in 2004, up from 1.9% in 2003. Is that a preview of further price acceleration this year?
Probably not. As with so many trends in this business cycle, the past is no longer prologue. True, uncertainty in the Middle East, as evidenced by the clashes running up to the Iraqi elections, clouds the outlook for oil prices. But more fundamentally, the inflation process in the U.S. has changed dramatically in the last decade. First, the Federal Reserve has built up an unprecedented credibility in the financial markets as an inflation fighter. That faith has helped to keep inflation expectations low. Second, intense global competition continues to limit pricing power even amid a weaker dollar and rising production costs. As a result, the corporate adjustment to higher costs tends to show up more in profit margins than in prices.
Third, the technology-fueled speedup in the long-term growth rate of productivity means the labor-input cost of producing a unit of output now grows more slowly at any given rate of growth in wages and benefits. And finally, the information revolution is having one other, often overlooked, effect: It has empowered buyers by giving them more knowledge of products and markets, taking away some of the pricing edge that sellers used to hold.
This new inflation dynamic creates important benefits for the economy. Price stability increases certainty, giving companies more confidence in the future and a greater ability to plan. In turn, certainty reduces volatility, a key reason why business cycles have become less severe. Clearly, in an uncertain world, price stability gives markets and executives one less thing to worry about.
THE BOND MARKET seems to have taken notice. In the fourth year of an expansion, bond yields usually would be rising significantly. But yields are no higher now than they were a year ago. Rates are back down despite last year's acceleration in economic growth, the runup in core inflation that excludes food and energy, and the five quarter-point hikes in interest rates taken by the Fed since last June, with unanimous expectations for another quarter-point increase at the Feb. 1-2 meeting. These factors typically would have turned bond traders into inflation-phobes.
Plus, in the past, nothing fueled inflation expectations more than rising actual inflation. But this time even that isn't true. Not only did oil lift overall inflation in 2004 but core inflation, which excludes energy and food, rose from 1.1% over 2003 to 2.2% during 2004. However, the measure of inflation expectations implied by the difference between the yield of a 10-year Treasury bond and that of a 10-year Treasury inflation-protected bond is only slightly higher now, at 2.4%, than it was at the start of 2004.
Undoubtedly, traders realize the exceptionally low rate of inflation in 2003 was an aberration, reflecting the lingering effects of the investment bust, the strong dollar, and a glut of global production capacity. Prices of core consumer goods actually fell 2.5% in 2003, something that hadn't happened since the Great Depression. A bounceback was inevitable in 2004. But even so, core goods inflation in 2004 rallied to just 0.6%.
Total core inflation is back in the same range -- about 2% to 3% -- that it had been in from 1994 to 2002. And it will likely stay there in 2005. Plenty of slack remains in the labor markets and in industrial capacity. And solid U.S. demand will continue to attract cheap Asian imports, which so far have been unchecked by the dollar's decline against the euro and yen.
THOSE ARE CYCLICAL TRENDS, though. What's more critical to the inflation story is the way technology, productivity, and global competition have structurally transformed corporate pricing behavior. That's one reason Fed Chairman Alan Greenspan and other Fed officials remain optimistic about the inflation outlook.
That's true even with productivity growth slowing, as it usually does when an expansion gains traction. Slower productivity means that unit labor costs will grow faster this year than in 2004. In the past, that has been an impetus for businesses to lift prices to maintain profit margins. Now, global competition has broken that trend. Greenspan noted in testimony last year that faster growth in unit labor costs will not threaten price stability if high profit margins come under more intense competitive pressures at home and from abroad.
As some Fed officials have come to believe, the degree to which rising unit labor costs are a short-run trend and not a structural change determines how businesses react. Companies know that a price hike risks a loss in market share, perhaps permanently. So for a short-run cost squeeze, it's a better strategy to shave margins a little instead of passing the costs along by raising prices.
For this year, the gain in unit costs will reflect the cyclical slowdown in productivity. Consequently, businesses should choose to absorb the rising costs in their profit margins rather than risk alienating customers.
Oil is a prime example. Higher oil prices now have little, if any, lasting impact on inflation, because higher energy costs are less likely to lead to higher prices elsewhere. During last year's oil shock, businesses reacted by abruptly scaling back their hiring and inventory-building as they waited for the effects to play out. And bear in mind that if oil averages $40 per barrel in 2005, as it did in 2004, the net contribution to the overall inflation rate will be zero.
IN ADDITION, INFLATION'S GRIP has eased because the information revolution has enabled price data to spread more quickly through the economy. As David Kelly, economic adviser at Putnam Investments (MMC ), has noted, information technology has leveled the playing field when it comes to pricing.
Sellers used to have the upper hand in the marketplace: They had all the information -- some of it proprietary -- about costs, markups, and competitors' prices. Now that information is available on the Internet. Buyers can easily comparison-shop before purchasing a range of items, from cars to airline tickets to mortgages. This access isn't limited to consumers. Players across the entire distribution chain, including commodity suppliers, manufacturers, wholesalers, and retailers, have it, too. "Information in transactions is power," says Kelly. This bargaining power is another reason to expect inflation to remain low.
To be sure, plenty of folks are still concerned about the inflation outlook -- and that group includes some in high positions at the Fed. Part of that worry can be traced to the possible unintended consequences of the Fed's unusually liberal policy in recent years. However, given the evidence, it appears that inflation is one area in which the economy truly has changed.
By James C. Cooper & Kathleen Madigan