FEBRUARY 2006 :: ECONOMICS

Seeds of Inflation?
As the Economy Recovers, Businesses Flex Their Pricing Power

BY JON E. HILSENRATH AND PETER SANDERS
Staff Reporters of The Wall Street Journal

The Waldorf-Astoria in Manhattan has long been among New York's pricier hotels, and it's getting even more expensive: A standard room in the middle of the week fetches $569 a night, up about $100, or more than 20% from a year earlier. The hefty increase shows that the hotel industry is gaining pricing power, the ability to raise prices without scaring away business.

Pricing power like this was unheard of a few years ago. While nationwide inflation figures indicate that the trend isn't pervasive, anecdotal evidence suggests that in hotels and many other sectors of the economy—from home appliances to Broadway shows—an increasing number of companies have gained some leeway to pass on higher prices to customers without sending them fleeing.

Among the reasons behind the trend are higher raw-material and energy costs, the reduction of excess capacity in some industries and the spending power of wealthy consumers.

Procter & Gamble, for example, says it has been able to beat back the pressure of soaring raw-material costs by pushing up prices for products like Prilosec, the over-the-counter heartburn drug, and detergents like Gain and Era. Hertz recently boosted car-rental rates by $3 per day, just two months after a $5-a-day increase. Last fall, 3M reported a 10% increase in earnings, thanks in part to price increases for products like Scotch tape and Post-It notes.

"Our pricing strategy this year has been key to our ability to maintain [profit] margins" in the face of significant raw-material cost increases, says Patrick Campbell, chief financial officer of 3M.

Fault Lines

Pricing power isn't uniform across the economy. While some sectors—like home appliances, car rental and airlines—have seen prices turn higher, other industries—such as household furniture, cellphones and toys—face continued pressure to keep prices low.

The fault lines between rising and falling prices depend on a variety of factors. In sectors where demand is strong, such as high-end hotels, companies have more leverage to raise prices. In sectors where competition from abroad is intense, like household furniture and toys, companies have less. Other factors, like high raw-material costs and the amount of spare production capacity in an industry, also play critical roles. Higher energy costs, for example, have driven up the price of Whirlpool's appliances.

Some industries have stumbled trying to figure out how much leverage they have. When the auto industry removed hefty rebates and other incentives on new cars in September and October, sales dropped sharply. Consumers, accustomed to big incentives from the Big Three auto makers, apparently believed they would do better if they held off buying. Indeed, General Motors and Chrysler later increased their discounts.

"This is a tug of war between the cyclical forces of pricing power and more secular forces holding inflation back—like globalization," says Richard Berner, an economist at Morgan Stanley.

‘A Very Fine Line'

Those competing forces are at play at 3M. In the past year, the company has increased U.S. prices on average by 2.9% to help offset a 6% increase in raw-material costs and widen its profits. But Mr. Campbell says there are limits to how far the company can go in raising prices. "It's a very fine line," he says. "There are very few segments that we don't have strong direct competitors in, where we just can unilaterally try to say, ‘Let's go take our prices up and risk [losing] all kinds of volume to competition.'"

Still, Mr. Berner sees the economy tilting toward more pricing power, not less. Among 45 industries tracked by Morgan Stanley analysts last fall, 15 were seeing price increases of more than 3% a year, while five industries had falling prices, according to Mr. Berner's research. Besides the energy business, companies in the personal-care industry, lodging, machinery, paper, electrical equipment, specialty chemicals, commercial aerospace and insurance were showing signs of more pricing power. A year earlier, only seven out of 42 industries were experiencing price increases of more than 3%, and 10 had falling prices.

In the early stages of recovery from the 2001 recession, many companies complained they had no pricing power. Intense competition from overseas and an abundance of production capacity—built up during the boom of the 1990s—meant companies risked losing market share if they dared to raise prices. Some companies managed to boost profits without raising prices by increasing productivity, or output per worker. That way they could produce more goods without higher labor costs.

Now, with the recovery entering its fifth year, the extra production capacity is slowly diminishing in some industries as demand picks up. That means companies in those industries have a little less to fear from their competitors if they push prices higher.

Pricing power is good news for corporate profits. But it's cause for concern at the Federal Reserve, which is charged with keeping a lid on inflation. Fed officials worry that high energy prices increasingly will be passed on to consumers, setting off a broader bout of inflation.

Already, elevated commodity prices have forced many business owners, large and small, to test the limits of their pricing power. Gasoline prices "really hit me bad, so I had to add it up," says Melih Ozel, who operates an ice-cream truck on New York's Long Island. He estimates his daily gasoline bill doubled to $30 from $15 last summer. To help offset the increase, he raised the price of an ice-cream sandwich to $1.25 from $1 before the ice-cream season ended in September. If gasoline prices don't go down some more by the spring, he says, his Choco Taco prices are likely to rise too.