The Economy's Pop-Tart Problem

Kellogg announced a 3% price hike for its products. That's bad news for U.S. consumer confidenceand its growing gap

Get ready to pay more for Pop-Tarts and Kellogg's Frosted Mini-Wheats.

Cereal giant Kellogg (K) said on July 28 that it will raise prices for its cereals and frozen foods by 3% beginning in September. The company said it was making the move because of the higher prices that it is paying for everything from grains and sugar to fuel. "This is the first U.S. cereal price increase we've taken in two years," says Jeff Boromisa, CFO of the Battle Creek (Mich.) company.

Consumers, already buckling under the weight of higher gas prices, higher interest rates, and a cooling housing market, now have one more thing to worry about: bigger grocery bills because of the higher cost of food staples.

Kellogg is no aberration. Steep price hikes are beginning to show up in the broad economic data. On July 28, the U.S. Commerce Dept. said that the price index for gross domestic purchases rose 4% in the second quarter, compared with an increase of 2.7% in the first. Even taking out food and energy, core inflation rose at a 2.9% annual rate in the second quarter, the fastest pace reported since 1994 (see, 7/18/06, "Target: The Canary in the Economy?").


  Consumer confidence is still relatively strong overall. The University of Michigan's consumer sentiment index slipped only a tad in July to 84.7 from the June sentiment of 84.9. But there's a huge split—a 30-point gap—between the confidence levels for people in the upper- and lower-income brackets. Households in the bottom third of the income distribution held significantly more negative views about their own financial prospects than the rest of the population, as well as a more negative outlook for employment and economic growth. "Higher prices have driven a wedge between upper- and lower-income households that now extends well beyond their personal financial situation," says Richard Curtin, the director of the University of Michigan's Survey of Consumers.

Economists say the size of the gap is unusual for times in which the economy is expanding. "This kind of a gap hasn't been seen except in recessionary periods," says Brian Bethune, economist for Global Insight, a financial analytic firm. "It highlights the fact that pain of high prices from food, gasoline, and utilities really hits the lower- and mid-income households pretty hard" (see, 6/27/06, "Still Safe to Count on Consumers?").

It's not just Pop-Tarts and cereal. Consumers will also be paying more for pasta, bread, cookies, and beer. Why? One reason is that the prices for wheat, corn, and sugar, which go into making these products, are at multiyear highs.


  But there's more to the story. In the past few years, food companies often haven't passed on costs as individual ingredients have gotten more expensive. But now they don't seem to have much choice because many of their other costs are going up at the same time, including their expenses for packaging and transportation, thanks to surging gasoline prices. That puts food companies under pressure from all sides.

Even Kraft Foods (KFT), a company that has lost market share in many of its food product categories, has raised prices. "Pricing was up…over the past year to cover higher energy and packaging costs," says Jim Dollive, CFO of Kraft Foods.

Commodity price pressure doesn't look like it'll abate anytime soon. The U.S. Agriculture Dept. says that world wheat supplies will dip to a 25-year low in the coming year because the California wheat crop is projected to be 29% smaller this year than last and a drought caused winter-wheat production to drop 16% this year. Wheat is now changing hands for as much as $4.30 a bushel, the highest price in 10 years.


  At the same time, high demand for ethanol has sent corn prices soaring to a 10-year high of $2.65 a bushel. That has led to a 20% increase in the price of high fructose corn syrup, which goes into the production of sugar and almost all things sweet—from cakes and cookies to juices and frozen foods. Of course, since farmers have to pay higher prices for corn to feed their livestock, the cost of chicken and eggs also climbed. In June, wholesale chicken prices rose 12.1%.

Food companies also don't have the luxury of relying on offshore production like apparel, footwear, and electronics manufacturers. Many of them have domestic factories that churn out pasta, bread, and cereal. "They have significant exposure to unionized labor costs," says Richard Hastings, economic adviser at the Federation of Credit and Financial Professionals.

Still, cereals and other foods are highly competitive areas, and often higher prices don't necessarily stick. Last year, General Mills (GIS), which makes Cheerios, increased prices slightly and lost market share to Kellogg. Its Honey Nut Cheerios still cost 1.2% more than last year and a box of Wheaties costs 5.8% more, both of which are now at $3.34, according to Information Resources of Chicago.

Hastings says that this time food companies might be under so much pressure that they all go along with price hikes. Kellogg's decided to take a chance that its rivals will follow its lead. If they do, it'll be consumers that pay the price.

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