Financial Insights on Retailing: Inflation Fears and Market Tears

An old Wall Street adage warns investors to “sell in May and go away.” Certainly, that would have been good advice to take this year as stock markets around the world suffered something of a nervous breakdown. The cause of this distress was a renewed concern over rising inflation.

Inflation is a concern because the loose lips at the Federal Reserve let it be known that after 16 hikes in short-term interest rates, the monitors of the nation’s money supply were ready to take a pause, if inflation was tame. For those with a short memory, the financial markets went through a similar spasm back in September and October when no less than eight regional Federal Reserve presidents came out and said they were worried about inflation. With all this worry, is there any substance to the fears of a resurgence of inflation? The short answer is, “No.” For the longer answer, please read on.

Energy Prices and Inflation
In the 1970’s and 1980’s, rising energy prices were one of the primary drivers of higher inflation. With energy prices steadily rising over the past three years, the fear of higher inflation would seem to be rational given their previous impact on prices. This time, however, has been very different. Even with oil prices tripling over their 2001 recession lows, rising energy prices have not set off the kind of spiraling inflation that afflicted the economy in the 1970’s or the 1980’s.

The primary reason for this is that energy does not matter as much as it once did. The rise of knowledge work and the service sector coupled with the reduced importance of manufacturing has made the U.S. economy much less energy intensive. Adjusting the price of oil for both changes in productivity and prices, the real adjusted price of oil is still nowhere near where it was in the early 1980’s.

For oil prices to have the impact of the price spike in the early 1980’s, the current price would have to rise another $100 a barrel from its current level. No commodity boom lasts forever. The combination of slower global growth and a price-induced search for energy alternatives will bring an end to this one, putting downward pressure on energy prices and inflation.

Trade and Investment Remain Deflationary
While the inflationary pressures of rising oil prices have captured news headlines, the forces of deflation remain firmly in place. The steady increase in U.S. imports means that lower-cost goods continue to enter the country, undermining the pricing power of domestic businesses. The outsourcing of services has added to the downward pressure on costs and prices, at the same time relieving an ever-growing shortage of skilled labor.

Business investment in information technology and productivity is accelerating. Business investment has soared in recent quarters. With profits up at a double-digit pace for 14 of the past 17 quarters, U.S. businesses have the wherewithal to continue their torrid pace of investment. The combination of increasing trade, outsourcing and business investment has produced the fastest sustained growth in productivity in 50 years. It is this growth in productivity that is keeping a lid on labor costs and pushing profitability as a share of the overall economy to its highest levels ever.

The China Syndrome
China is having a perverse impact on prices worldwide that gives a false impression of inflation. Everything China is buying to build up its infrastructure, including steel, copper, cement and oil, is going up in price, while the consumer products China sells like apparel, toys, shoes and consumer electronics are going down in price.

While the rise in commodity prices, particularly oil makes headlines nearly every day, the steady decline in the price of such mundane items like toys or apparel barely gets noticed.

Implications for Retailers
The most important goal of the Federal Reserve is price stability. In this task, they are being helped by increased globalization and the rise in business investment in technology. While dramatic moves in financial markets will always captivate the attention of the business media, the more mundane long-term changes in the underlying fundamentals of inflation receive little notice.

Inflation remains steadfastly under control. Few retailers have the luxury of pricing power over their products. Competitive pressures within the retail industry work to keep prices down and margins under pressure. Under these conditions, the only path to continued profitability growth is productivity.