Health Care and Economy and Environment and Government

ECONOMIC ANALYSIS: Prices recover in 2004; expect same in 2005

January 3, 2005

A few weeks of big price changes, particularly on the up side, and the armchair economists seem to really come out of the woodwork.

Oil prices peaked in October at levels 40-percent higher than in July, and so did rumblings about conspiracies, windfall profits and pricegouging. To hear some lunchroom 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 such as health maintenance organizations 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 marketplace 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 overall inflation will come in at just 2.5 percent in 2004, as measured by the price deflator 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 as 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 service 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 such as energy, cement, metals and wood products have risen significantly in the last 12 months. The Producer Price Index for crude materials was a whopping 25.5-percent higher in November 2004 than 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 such as 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 three 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 of prices? Most forecasters are betting 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.



Barkey is an economist and director of economic and policy studies at the College of Business, Ball State University. His column appears weekly. He can be reached by e-mail at pbarkey@ibj.com.
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