December 24, 2004
Evaluating the Price Environment
A few weeks of big prices changes, particularly on the up side, and the arm chair economists seem to really come out of the woodwork. Oil prices peaked in October at levels 40 percent higher than they were in July, and so did rumblings about conspiracies, windfall profits, and price gouging. To hear some lunch room conversations, as well as the saber rattling of some attorneys general around the country, the only thing that keeps businesses of all kinds from fleecing the American public with unconscionable prices is the watchful eye of the law.
That’s nonsense, as anyone who has ever run a business can certainly attest. But it speaks loudly about the obvious fact that many, if not most, Americans have little idea where prices come from.
In the special case of health care, where third parties like HMO’s and government agencies end up paying the tab, you can add most economists to that group. We don’t understand where prescription drug prices come from, either. But for just about everything else, forces in the market place that are beyond the control of any individual actor in the economy, determine what direction prices will go.
And those forces have produced an amazingly stable and benign price environment in recent years, when judged by historical standards. In the big picture, despite the jump in energy prices, we expect that overall inflation will come in at just 2.5 percent in 2004, as measured by the pricedeflator for Gross Domestic Product. That’s higher than the 1.8 percent rise in 2003, but substantially lower than the average rate of 3.7 percent since 1960.
The last time we saw energy prices spike like they have this year was in 1980, when they shot up by more than 50 percent. In that same year, overall inflation was 9 percent. What’s different today?
Just about everything. Businesses today operate in a much more competitive environment that makes it much harder to simply pass cost increases along to final customers as they once did. That’s not true of all businesses, of course, especially in services industries. And it’s not certain to continue.
That’s because upward price pressures have been unrelenting in recent months for many kinds of businesses. The prices of raw materials like energy, cement, metals, and wood products have risen significantly in the last twelve months. The Producer Price Index for crude materials is a whopping 25.5 percent higher in November 2004 than it was one year ago.
But businesses have been able to swallow some of those increases, thanks to higher margins on export sales, efficiency improvements, and other adjustments. And they have also been able, for the first time in years, to pass some of the costs along as well. The price increases in items like capital equipment, while still very tepid at just 2 percent over last year’s levels, are running stronger than at any time in the last 3 years.
Unfortunately for domestic motor vehicle manufacturers and suppliers, the brutally competitive car market is not one that is receptive to price increases. Years of very high production levels have created a huge supply of lightly-used vehicles, and even after recovering a bit from September’s low, new vehicle prices stand just 0.3 percent above last year’s levels. With costs escalating from crude materials and health care, it’s a squeeze on earnings that is more than some weaker companies will be able to handle.
Will 2005 be another year of tame behavior by prices? Most forecasters are betting that it will be. And while that news may make some sellers fret, it’s been a key ingredient to the durability and strength of our economic engine.
About the Author
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