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By
Reuters
Published
Jun 3, 2008
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Stagflation recipe missing one key ingredient

By
Reuters
Published
Jun 3, 2008

By Emily Kaiser - Analysis

WASHINGTON (Reuters) - Dow Chemical Co hiked prices on products used in everything from diapers to antifreeze. American Airlines wants $15 to check your luggage. Then there's $4 gasoline and those rising grocery bills.

But for all the worry over inflation, the U.S. economy is actually in little danger of returning to the 1970s stagflation era of rising prices along with stagnant growth. There is one key ingredient missing -- higher wages.

"It is utter nonsense, in our view, to be talking incessantly about stagflation," Merrill Lynch economist David Rosenberg wrote in a note to clients, pointing to strong productivity gains and flat wages.

Three decades ago, when inflation was soaring and the U.S. Federal Reserve had to drive up interest rates to get it back under control, powerful unions had the clout to push for higher pay to compensate for rising prices.

That power is largely gone now.

"Instead of running out and going on strike for higher pay, people are adjusting by driving less, riding their bikes, car-pooling, or using mass transit," Rosenberg said.

The end result is that the U.S. economy will likely escape the vicious spiral of rising costs leading to wage increases and still higher costs. Instead, the pain of expensive food and energy will show up in the form of diminished household buying power, poor consumer confidence, and shrinking corporate profits as companies are forced to absorb the higher prices.

The Institute for Supply Management's monthly survey of factory activity, released on Monday, tells the story quite plainly. Industries ranging from apparel to plastics -- some 17 in all -- reported paying higher prices for supplies.

The index of prices paid jumped to its second-highest reading in 25 years, according to JPMorgan economist Michael Feroli. If it weren't for strong export demand, the manufacturing sector would be in serious trouble.

"Most manufacturers feel that they can't afford not to try to pass along those prices," said Norbert Ore, who chairs ISM's manufacturing business survey. "They have to try to get some price relief."

THE MIDDLE MAN

While some of the price increases will certainly filter through to the consumer level, nudging up the consumer price index in the coming months, companies will have a hard time convincing consumers to pay more for anything but necessities.

Discretionary spending has tumbled, and corporate profits are already hurting. In the first quarter, U.S. corporate profits were up a slim 0.3 percent -- and that was only because of a 1.3 percent gain in overseas earnings. Domestic profit growth was virtually nil.

Brian Bethune, chief U.S. economist with Global Insight, said auto makers tried and failed to recoup some of their rising costs by cutting back on incentives. The result was a deep decline in sales, leaving them with little choice but to absorb the rising prices.

"Unfortunately, it's just a margin issue," he said.

Companies that sell goods overseas are in a better position because a weak U.S. dollar gives them more wiggle room to pass along the higher prices, Bethune noted. Those without export channels have a big problem.

The Labor Department's monthly report on producer prices confirms that companies are taking the brunt of the inflation hit. Prices of crude goods rose by 3.2 percent in April, while intermediate goods were up a more modest 0.9 percent and finished products just 0.2 percent.

When Dow Chemical announced its price hikes last week, Chairman and Chief Executive Andrew Liveris said the company had no choice because its energy-related costs were on a pace to quadruple from 2002 levels.

"Our first quarter feedstock and energy bill leapt a staggering 42 percent year over year, and that trajectory has continued, with the cost of oil and natural gas climbing ever higher," Liveris said.

Other companies including film and camera maker Eastman Kodak Co and chemical company Huntsman Corp have also announced big price increases recently.

But at the same time, a host of other products are getting cheaper, easing the inflation pressure. It is perhaps most noticeable in autos, where many consumers are switching from pricey, gas-guzzling SUVs to smaller, cheaper cars. U.S. inflation data also shows falling prices for clothing and home furnishings.

While that may not be enough to make the Federal Reserve comfortable with its double duty of keeping prices in check while promoting growth, it should help keep the overall inflation rate well below the headline-grabbing price of oil. And it may be enough to keep interest rates on hold longer than many investors expect.

(Additional reporting by Ellen Freilich in New York; Editing by Andrea Ricci)

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