Sources of the current low-inflation environment in manufacturing

Business Economics, Oct, 1997 by Daniel J. Meckstroth

The mechanism by which lower rates of inflation spread through the economy is not well understood. It is clear that the Federal Reserve can, within certain limits, slow the growth in the money supply relative to the economy's growth in productive capacity, reducing demand and creating disinflationary pressures. The nation's monetary authorities, however, do not have control over how individual products, industries, or even sectors behave as disinflation works its way through all the economic transactions conducted in the United States.

An outcome of the Federal Reserve's tightening (most visible in the form of higher short-term interest rates) is that some industries tend to be impacted more than others by the disinflation process. One way to explain the link between disinflation and manufacturing is to assume zero inflation. In a zero-inflation economy, prices still must fluctuate to keep markets' supply and demand in balance. The prices for those goods and services that are more in demand would increase - the market's signal to producers to supply more of those particular goods and services. On the other hand, prices of goods and services for which there is less demand or which had experienced very rapid growth in productivity would decline. As low rates of inflation continue in the United States, it is important that business managers understand the forces contributing to the current low-inflation environment.

MANUFACTURING IS A LOW-INFLATION ENVIRONMENT

The anecdotal evidence from business is that it is very difficult to increase prices today. This description of the current pricing environment is supported by data. The "core" rate of inflation for finished goods, producer prices for finished goods excluding food and energy products, declined from 4.4 percent in 1989 to only 1.0 percent in 1994. Then after rising 2.1 percent in 1995, the producer price index rose only 1.5 percent in 1996. During the past five years, the core inflation rate in finished manufacturing goods has averaged only 1.6 percent a year.

GLOBALIZATION

Developed countries around the world are experiencing disinflationary forces similar to those in the United States. The United States, when compared to most European economies and Japan, has a relatively high rate of inflation in consumer prices. Canada, Japan, Germany, France, Sweden, Switzerland and the United Kingdom, to name a few, had a lower inflation rate in 1996 than that of the United States.

One reason for the modest rate of inflation in consumer prices in Europe is that the European Union (EU) has set aggressive targets for countries that intend to participate in the Economic and Monetary Union (EMU). Italy's 3.9 percent inflation rate was the highest among the developed nations in Europe in 1996. France and Germany posted inflation rates of only 1 to 2 percent. The United Kingdom, which does not intend to participate in the EMU, experienced a 2.4 percent inflation rate. Furthermore, Japan, which continues to be in a recession, has had virtually zero inflation for the past two years. Closer to home, Canada has experienced inflation rates lower than those in the United States for the past five years.

Low domestic inflation rates among our trading partners, a competitive worldwide marketplace, and, more recently, the appreciation in the value of the dollar in international markets have restrained price increases on goods that the United States purchases from abroad. Figure 1 shows the percentage change in producer prices for U.S. finished goods excluding food and energy and the inflation rate for imported goods excluding food and energy imports. Price increases were less for imported goods than domestic goods in five of the past seven years. Inflation in imports exceeded that in domestic goods only in 1994 and 1995. Foreign competitors cut their prices about 1 percent on goods sold to the United States in 1996.

This suggests that foreign competition plays a major role in the disinflation process within manufacturing. Many imported products are manufactured in less inflationary economies than that in the United States. As a partial explanation, many of the European economies and Japan have experienced recessions or prolonged periods of slow growth. As a result, these countries are eager to export to the United States and are willing to do so at highly competitive prices. This intense price competition from abroad helps to slow price increases for domestically manufactured goods.

MANUFACTURING CAPACITY GROWTH ACCELERATES

Another reason for low inflation in manufacturing, in the midst of a relatively strong business environment, is that factory capacity has more than kept pace with demand. Manufacturing capacity grew about 2 percent a year on average between 1987 and 1993. Then starting in 1994 the growth rate of factory capacity began to accelerate. Manufacturing capacity grew 2.6 percent in 1994, 3.5 percent in 1995, and 4 percent in 1996. Through the use of advanced manufacturing techniques and improved management of inventory, manufacturers have freed up floor space, enabling them to add new equipment to expand capacity quickly. In addition, a few industries, like computers and semiconductors, have invested heavily in capital expansion. The faster growth in capacity contributes to low inflation, because production has expanded less rapidly than capacity. Manufacturing firms can actually have falling factory utilization rates in the midst of a moderately paced business expansion.