Back to the Future: Will Rising Commodities Prices Create a New ‘Inflation Generation’?

Commodities prices are surging — from oil to cotton to grains to gold. These higher costs pose challenges for companies in industries like apparel, food retailing and appliances as they try to pass on price increases without alienating consumers still weary from a recession and the threat posed by high unemployment. At the same time, higher commodities prices raise the specter of a spike in inflation down the road, a major concern for policymakers and the Federal Reserve.

The ramp up in prices for commodities reflects both broad global economic developments, as well as conditions very specific to certain industries. In the oil markets — where oil is now trading at more than $110 per barrel — the civil war in Libya on the heels of unrest elsewhere in the Middle East has disrupted some oil supplies and raised worries about the stability of crude production from that part of the world. Those higher oil prices in turn contribute to higher prices for other commodities that require a good bit of energy for their production, notably metals and some agricultural products.

Meanwhile, the agricultural sector has been a major contributing factor to escalating prices in other markets. Bad weather in China and Pakistan has resulted in diminished cotton output from those regions, while weather instability has hurt wheat crops in Russia and Canada and corn and soybean production in the U.S. The result? Climbing prices. Cotton prices alone are up threefold over the last year.

The slump in production couldn’t come at a worse time. Fast growing economies around the globe, particularly in Asia, have a growing appetite for consumer goods, a trend that increases the demand for many of these commodities. And as rising commodities prices stoke fears of inflation, and geopolitical uncertainty increases with conflicts in the Middle East and the crisis in Japan, investors go hunting for holdings that are attractive in turbulent markets. That is often commodities, particularly gold, which is approaching $1,400 per ounce.

But while the rise in commodities prices is certainly painful, experts note that it is hardly as onerous as the high inflation period of the 1970s. The U.S. economy is actually better positioned now to deal with a rise in oil prices in particular than it has been in the past, says Wharton finance professor Jeremy Siegel, noting that the amount of energy used to produce $1 of GDP in the U.S. is about half of what it was during the oil shock of the 1970s. This stems in part from the shift in the U.S. away from manufacturing and toward services. “We are not as sensitive to these swings in energy prices as we were 40 years ago,” Siegel adds.

In addition, some of the strategies companies used back then can help them weather the storm today. According to Wharton marketing professor David Reibstein, companies will often reduce the size of an item in order to hold the price steady. So a company may still sell a bottle of its product for $1.95, for example, but the container may now hold 7 oz. instead of 8.5 oz. “People notice price increases more than they do reductions of portions,” Reibstein says.

In fact, companies facing an unwelcome increase in their costs typically try to hold the line on prices when possible. “Manufacturers tend to absorb some of the pain,” notes Wharton marketing professor Stephen Hoch. “They are afraid of passing too much [of those costs] on to their retailers because they worry competitors won’t do the same. I can see some companies leaving money on the table in the short run [by holding prices steady] because they don’t want to lose market share.”

According to Barbara Kahn, a Wharton marketing professor and director of the Jay H. Baker Retailing Initiative, this approach makes sense. She says consumers typically have a negative reaction that is more intense when prices go up than the positive response they experience when prices go down. “Losses loom larger than gains” in consumer’s minds, Kahn contends. That’s why she expects many companies to get creative about trying to deal with rising costs, whether that is substituting less expensive materials for the more expensive inputs or redesigning products so they consume less of the expensive commodities.

Kahn points out that the recent recession has pushed margins down for many retail and apparel companies, making the rising commodities prices even more unwelcome. “Right now, the retailers are working on thinner margins than they had in the past. The question is how do they preserve their margins [as costs rise]. They are busting at the seams to raise prices, but consumers right now are tentative and price sensitive.” Hoch notes that many apparel makers had already made moves to cut the costs of producing their products, including stripping out extra frills and waste. “They have less levers to push right now to keep the lid on costs.”

Spreading the Pain

In some industries, hedging strategies can dampen some of the downside of rising costs. The airline industry, for example, typically hedges on energy costs. But Siegel says companies need to limit this practice. “If you over-hedge, you can be in bad shape if prices come down. In that case, you are locked into higher prices, and your competitors can undercut you.”

With no sign of a reversal of this trend toward higher commodities prices, a number of companies in recent months have announced price hikes. Hanes, Gap and Abercrombie & Fitch, hurt by the higher cost of energy and cotton, have begun raising prices. Kellogg is upping the price of its cereals, and Procter & Gamble and Kraft have signalled they may introduce their own hikes. Appliance maker Whirlpool, stung by higher steel prices, put through price increases in April. On the other hand, Swedish company Hennes & Mauritz, parent company of the trendy H&M brand, recently reported a 30% drop in first quarter earnings because the firm opted to spare consumers the brunt of rising cotton prices, higher energy costs and a strong Swedish krona.

According to Hoch, the trend of rising prices may seem foreign to some consumers. “For about 20 years, we have had no inflation, and in some areas like clothing we have had deflation. A good chunk of people in this country under 40 years of age haven’t really experienced inflation.” He says that is one reason companies are announcing their plans to raise prices, a way of “testing the waters” to gauge consumer reaction. “Memory for prior price bubbles is not that great at the institutional level, and sometimes people still get caught flat footed, such as the case with cotton, where volatility traditionally has not been all that great.”

Reibstein says it is critical for companies to communicate why prices are going up. “Businesses find it relatively easier to raise prices when they put together a story on how their costs are going up. You can get away with doing it when people understand why you are taking that step.” And in some ways, he notes, the pressure to raise prices creates an opportunity because consumers typically get accustomed to the new higher price and companies are not pressured to cut their prices when input costs later decline.

As for the danger in moving too aggressively to up prices, Reibstein predicts consumers may switch to lower-priced private label products if the price differential is great enough. “The risk is that people switch from national brands to the store brands and discover they aren’t that much different. [Consumers] become accustomed to those cheaper options.”

That’s why many companies would be better served looking for ways to target their price increases to minimize customer ire, according to Wharton marketing professor Z. John Zhang. “You don’t have to increase the price for all products and for all customers. You can also differentiate by region of the world because there are some customers who are better positioned to absorb the higher cost.”

Zhang says one way to do this is to charge certain customers higher prices, but in return give them priority if products are in short supply. They may be willing to pay a premium to ensure their access to the product. Or, he points out, firms can enhance the services they offer in connection with a higher priced product to offset the sting of the hike. He suggests that companies may also want to consider rolling out a value offering, a product that uses less of the expensive commodities and that is aimed at customers who can’t afford the higher prices.

A Recipe for Inflation?

As consumers watch their bills rise for a variety of products and services, the question becomes what this trend means for the inflation rate. Federal Reserve chairman Ben Bernanke has made it clear that the current higher level of commodities prices is not a concern. His view is that commodities costs are a relatively small percentage of overall costs for consumer goods — so the upward pressure on prices right now is modest. In addition, he has argued that for inflation to take off, wages must begin rising at a strong clip, something that is unlikely at the moment given that unemployment continues to hover around 9%.

Chris Christopher, senior principal economist at IHS Global Insight, agrees. “To get an inflationary spiral, wages need to go up substantially,” Christopher notes. “While labor markets have been improving, that doesn’t look like it’s going to happen any time soon.” Adds Chris Lafakis, an economist at Moody’s Analytics: “There is a lot of slack in the labor market. That is not a recipe for runaway inflation.”

Still, Christopher says there is evidence that consumers are growing worried about inflation. “Surveys that track consumer mood have shown inflation expectations have been dramatically increasing since December,” Christopher points out. In particular, Hoch says higher gas prices can have a major impact on consumer perception. “They are noticeable to people because you drive past them every day and there is a lot of repetition. Even though it is not included in the core [Consumer Price Index] numbers [which the government tracks as an inflation measure], it has a real impact on people’s feelings about how much things cost.” If the labor market strengthens significantly and consumers continue to fret about inflation, workers will be more likely to press for wage hikes — a force that could begin to drive the inflation rate higher.

There are some outside forces, of course, that could contribute to a higher inflation rate as well. The Chinese economy is one factor. According to Lafakis, if the Chinese yuan appreciates significantly — and Chinese authorities are allowing some appreciation now to combat higher inflation there — that will raise the cost of goods the U.S. imports from China. That, in turn, could push the U.S. inflation rate up.

But Lafakis says the risk of a major oil shock is also a concern. Because oil prices have such a ripple effect on other commodities prices, a sustained increase in crude prices has major ramifications. In a recent report, Lafakis modeled what would happen to the U.S. economy if oil prices spiked to either $125 per barrel or $150 per barrel. In both cases, inflation expectations would surge and exports would be crimped. But while the U.S. economy would still grow with $125 per barrel oil, the $150 scenario showed the economy slipping into recession and unemployment climbing to 10.7%.

As for the long-term trend on commodities prices, there is some debate on whether the current uptick is a sign of things to come. Siegel expects many commodities to actually decrease over the long term. Whether it is oil production or agriculture, Siegel predicts those markets will eventually grow more efficient. “Emerging markets don’t use the most efficient farming methods,” Siegel says. “Over time, increased efficiency should drive prices down.”

Zhang takes a different view. “All these commodities [price] increases are driven by economic development in countries like China, India and Brazil,” he notes. “The economic growth of those countries will continue and the pressure on commodities prices will be there. I don’t see how prices can go down.”

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