Is pricing power a threat?

The Jakarta Post ,  Jakarta   |  Wed, 05/16/2007 7:52 AM  |  Opinion

Paul Donovan, London

The world economy may be slowing, with growth data from the United States disappointing consensus estimates in the first quarter, but investors and central banks do not seem able to relax on inflation. Commodity prices remain relatively firm, and wage pressures seem to be building. These cost pressures are starting to raise questions about whether firms have the ability to substantially raise prices.

Cost pressures clearly exist in the global economy. The Journal of Commerce index of industrial commodity prices has risen roughly 17 percent since the start of 2006, as raw materials prices (including of course oil) have gained. Wage pressures also seem to have increased -- the influential German trade union, IG Metall, have just announced a pay settlement of 4.1 percent from June of this year onwards. This is not the 6 percent that was being demanded, to be sure, but it is at the upper end of economists' expectations for the pay settlement.

These higher cost pressures have been augmented by higher food prices in several economies, and this has resulted in some surprises when it comes to consumer price inflation. Inflation measures have been more likely to surprise the market consensus by coming in higher than forecast rather than lower than forecast. Does this mean that pricing power has returned, and companies are more able to pass along cost pressures? If that is so, does this in turn suggest that inflation risks will return to haunt financial markets?

In fact, we should probably be cautious about how strongly we emphasize the inflation threat in the world economy. Although there is little evidence of the disinflation forces that were a feature of the 1990s, there is also little evidence that pricing power is about to make a comeback.

Inflation has tended to surprise economists by coming in higher than expected, but that does not mean that inflation itself is rising. The surprises on inflation have tended to mean that inflation has not fallen as rapidly as economists anticipated, rather than there being an actual increase in the pace of price gains. U.S headline inflation has risen in recent months, but is still below the average levels of 2005 and 2006.

Moreover the core inflation rate (excluding the volatile food and energy components) has been falling from its September 2006 high point. Euro area inflation has been moving sideways for seven months, and the last six months have averaged the lowest rate since 2000. Core European inflation is somewhat higher than in the last few months, but hardly alarmingly so. Japan, of course, still has deflation rather than inflation.

More significantly, the evidence of pricing power from companies themselves remains generally subdued. The U.S Philadelphia Federal reserve asks companies what their expectations of prices are for the coming six months. The survey results show a strong correlation with the eventual outcome -- in other words, U.S. companies have a considerable amount of self awareness when it comes to their ability to raise prices.

Recent months have shown a stable anticipation of future prices, slightly higher than in the late 1990s, but with no acceleration in evidence. The overall level is suggesting manufacturing prices will rise at around 2 percent to 2.5 percent over the year. Eurostat compile a similar survey for European companies, and again European companies exhibit a strong correlation between expectations and reality The European survey has been signaling stability in terms of future pricing power, again suggesting that a further acceleration of inflation is unlikely.

Likewise in Indonesia, inflationary pressure has been easing since the double digits peak that followed the removal of fuel subsidies in late 2005. While current inflation rates around 6.3 percent appears high relative to developed countries readings, cost pressures have been contained rather effectively by government measures to stabilize important food and raw material prices, such as rice and sugar, via the temporary removal of rice import ban and higher issuance of sugar import permits.

At the same time, with Indonesia being a key commodities producer, it also means that the domestic economy is less vulnerable towards the current trend of commodity price rises. A stronger currency in recent times also helps to keep imported inflation low. Core inflation in fact has come down to a low not seen since January 2004. Finally, on the demand side, relatively lackluster consumption and investment growth will continue to keep increases in producer's pricing power at bay.

Overall, the pattern of price data does not suggest that there is a global inflation threat per se. The pattern of data suggests that the forces for disinflation, that were a feature of the 1990s, are now fading from the global economic environment. This would account for the fact that inflation has tended to surprise economists by coming in higher than anticipated -- economic forecasts have been built on the assumptions of the disinflation environment of the last few years, and do not perhaps account for the end of the disinflation phase. This would also account for the stabilization of pricing power, albeit at a level slightly higher than it was in the late 1990s, in the surveys of corporate sentiment.

This is not an environment that causes significant concern about the level of price inflation in the world economy -- though central banks will need to remain vigilant. However, equity investors may wish to consider the profit growth implications of higher costs in the current subdued pricing power world.

The writer is Managing Director of Global Economics, UBS Investment Research. This is a personal view. He can be reached at paul.donovan@ubs.com.

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