News: Analysis & Commentary
THE ZERO INFLATION ECONOMY
With prices stable--and even falling--expect higher growth, lower rates, rising productivity, and more investment
Since inflation skyrocketed into double digits in the late 1970s, central bankers around the world have focused on one main goal: achieving price stability. To control fast-rising prices, policymakers in the U.S., Britain, Germany, and Japan were prepared to absorb years of slow growth, and if necessary, deep recessions.
But 20 years of single-minded inflation-fighting may be ending. In a groundbreaking speech to the American Economic Assn. on Jan. 3, Federal Reserve Chairman Alan Greenspan cited "the remarkable progress" that had been made in achieving low rates of inflation. Greenspan's message was clear: The U.S. is finally close to reaching price stability, a level of inflation low enough that it doesn't affect business or investment decisions.
RIPPLE EFFECT. The numbers tell the story. Despite strong growth, core inflation ran at only a 1.8% annual rate over the last six months. Service inflation is falling in housing, education, and other areas of historically persistent price increases. Goods prices, excluding food and energy, have actually declined since mid-1997. Moreover, Greenspan and other economists now believe that the official CPI overstates inflation by at least a percentage point. That means the U.S. is actually approaching what many forecasters did not think possible: the zero-inflation economy.
The benefits of zero inflation are already rippling through the entire economy. In a low-inflation environment, corporations are better able to plan and make decisions, since they no longer face the prospect of sudden inflationary shocks. Long-term interest rates fall as investors become more willing to lock up money for years because they are less fearful that the value of their investments will erode. And with inflation under control, the Fed can allow expansions to run longer, avoiding the boom-bust cycles which have led to recessions in the past. That means the Fed now has room to cut rates if economic growth should slow because of the Asian crisis or for some other reason (page 30).
The result? Higher levels of growth, lower interest rates, more capital investment, and rising productivity. A 1996 study by two Federal Reserve economists suggested that in countries with moderate inflation, a substantial reduction in the rate of price increases could add a half percentage point to the growth rate.
Moreover, low inflation perpetuates itself in a virtuous cycle. With long-term rates below 5.8%, their lowest level since the government first started issuing 30-year bonds in 1977, companies are more willing to invest in productivity-enhancing machinery and equipment. Those improvements will enable them to prosper without raising prices, producing the earnings to make further investments.
NEW DANGERS. For consumers, low inflation means that moderate wage gains can translate into decent improvements in their real standards of living. Over the last year, wages and salaries have risen by only 3.4%--but that still substantially outpaces consumer inflation.
That's the good news. But a zero-inflation economy brings new dangers as well--specifically, the possibility of deflation. Deflation, or falling prices, can be a positive sign if it is caused by rising productivity. But in his speech, Greenspan spoke of the damage that could be done by runaway deflation which pulls down the price of assets such as stocks and real estate.
In addition, a smooth macroeconomic ride does not protect some companies from rude shocks. Price stability means that the cost of raw materials and other inputs won't rise very much. But, at the same time, companies find it difficult to command more for their output. And in industries with global overcapacity, such as steel and autos, companies could see earnings hit hard by falling prices.
That's especially true in sectors facing competition from Asia. Over the last six months, the dollar has risen by 16% against the yen, 86% against the Korean won, and 244% against the Indonesian rupiah, enabling Asian rivals to put U.S. companies under severe price pressure. The pressure could intensify as Asian nations try to export their way to economic recovery. "If the Asian financial problem doesn't get corrected in the next 12 months or so, there could be goods dumping," warns Paul H. O'Neill, chairman and chief executive of Aluminum Corporation of America.
There's also the fear that companies will face a profit squeeze if they must pay more to keep workers in a tight job market, but can't pass on the cost in price increases. Despite the low unemployment rate, however, that hasn't happened yet. One reason is that a surge of college-educated workers--the crucial resource for many companies--has entered the workforce over the last two years, relieving some pressure on hiring. From March, 1995, to March, 1997, the number of people over 25 with college degrees rose by 6.4%, far outpacing the 4% increase in the number of jobs.
The companies that are most in danger of seeing price stability turn ugly--to serious deflation--are those in commodity businesses. The most outstanding example is oil. Wall Street analysts are now calling for 1998 profits of oil producers to fall 2%, according to researchers First Call Corp., down from the forecast of flat profits a month ago.
And those figures could prove optimistic if the price of oil, which has dropped from $22 a barrel to less than $17 over the past three months, continues to fall. Demand is low, inventories are high, and the number of new billion-barrel oil fields keeps growing. "Every single indicator is bearish," says Michael C. Lynch, an oil researcher at Massachusetts Institute of Technology. "I think that we could see sharply lower prices this year."
Copper prices, too, are down 30% since August. That's hurting Phelps Dodge Corp., the biggest copper producer in the U.S and among the biggest worldwide. Every penny move in the per-pound price of copper is worth about $17 million in cash before taxes to the company, says vice-president and treasurer Thomas M. Foster.
Steel producers are being hit by excess capacity, and by a slowdown in overseas demand. Prices for flatrolled steel, which have been falling since mid- 1997, are now at $310 per ton, not far from what many analysts say is the break-even price of $290 for many integrated steelmakers. And things could get worse: On Jan. 6, minimills Nucor Corp. and Ipsco Inc. both announced plans for new plate mills in the U.S. "There's a risk now that profits will be off the first half of the year," says PaineWebber Inc. analyst Peter F. Marcus.
PRICE WARS. Still, for every company hurt by falling prices, another company is profiting. Falling copper prices make copper cable less expensive. Depressed steel prices benefit big users of steel, such as the auto companies. And not least, falling oil prices help bring down inflation across the economy. According to estimates by Standard & Poor's DRI, a $5-per-barrel drop in the price of oil would take three tenths of a percentage point off the inflation rate over the next five years.
Pillowtex Corp., one of the country's largest makers of home textiles--including sheets, towels, pillows, and comforters--is benefiting from deflation in cotton prices, which are down about 10% from a year ago and 35% from three years ago. "That should be a net winner for us in terms of profit opportunity," says CEO Charles M. Hansen Jr., even though prices in home textiles are not rising.
For consumers, of course, the benefits of the zero-inflation economy are undeniable. Prices are dropping on everything from autos to home computers to sporting goods and, in some categories, full-fledged price wars rage. Take soft drinks. Now, a two-liter bottle of Coke or Pepsi sells for about 59 cents in some stores, compared with $1 before the two companies started their price war last May. Meanwhile, the prices of appliances and consumer electronics continue to decline as they have for years. Deflation "is not new news to us," says W. Alan McCollough, president of Circuit City Stores, a large consumer electronics chain based in Richmond, Va. "For us it's business as usual."
Consumers are also benefiting from slowing inflation in the service sector. Take housing, which accounts for about half of the services component of the CPI. Despite perceptions of tight housing markets everywhere, "rent of shelter," as the Bureau of Labor Statistics calls the price of housing, is rising at only a 3% annual rate over the last six months, down from 3.2% over the previous six months. The price of building new homes also has been restrained compared with previous expansions. "You're seeing some increase in materials, but moderately so," says homebuilding industry executive Leonard Miller, chairman of Miami-based Lennar Corp.
Surprisingly, even price increases for college, seemingly immune to market forces, have slowed sharply since the early 1990s. That's according to a draft report, not yet public, from the National Commission on the Cost of Higher Education. "In the last two or three years, the situation has changed dramatically," says Martin Anderson, senior fellow at Stanford University's Hoover Institution and a member of the commission. According to the commission, the total cost of attending public universities--tuition, room, board, books and fees, less grants--rose less than 3% a year from 1993 to 1996, down from an annual increase of 12% over the previous six years. Private universities showed a similar decline in cost inflation.
For operators of many service businesses that can still command price hikes--in travel, for example--the low-inflation economy is a boon. Consider Dallas-based Bristol Hotel Co., the largest Holiday Inn franchisee in the country with 86 wholly owned hotels. According to CEO J. Peter Kline of Bristol, falling prices on computer equipment and utilities such as phone service are helping the bottom line. Bristol has even created a new unit within its purchasing department to buy utility services on a competitive basis nationwide.
On the other hand, there are service companies that can't raise prices. "Pricing has been flat for the last 12 months," says James E. Ksansnak, vice-chairman of Philadelphia-based ARAMARK Corp., which provides a wide range of business services including food, uniforms, and other support services to corporations.
Overall, the new low-inflation environment leads to a delicate balancing act for companies. Take Illinois-based W.W. Grainger Inc., one of the largest distributors of industrial supplies, ranging from pumps and motors to tools. It has 80,000 items in stock and can buy more things at a lower price now. But the company is apprehensive about possible price declines for what it sells. "We don't dismiss a deflationary spiral as ridiculous," says John A. Schweig, a senior vice- president at Grainger.
Chemical companies, too, are seeing both the positive and negative sides of the zero-inflation economy. With oil prices dropping, the cost of one of their main inputs is going down. But the industry, which has a hard time raising prices even in a strong economy, is also sensitive to potential global overcapacity. "If Asia stays weak, we haven't got an optimistic view for 1999," says David R. Thomas, senior economist at Imperial Chemical Industries PLC.
Still, absent a deflationary collapse, price stability is a good thing. It took a long time for companies and consumers to get used to inflation. Now they are learning how to live with zero inflation--and love it.By Michael J. Mandel in New York with bureau reportsReturn to top