Don’t Look Now …

Here comes inflation.

While U.S. consumers have been forced to pay more for gasoline, they have generally been insulated from the ravages of inflation. The Consumer Price Index, which measures inflation experienced by individuals, rose 3.6 percent in the 12 months ended in August 2005, a period in which the price of energy rose 20.2 percent. But that doesn’t mean that inflation isn’t extracting an economic cost. The Producer Price Index measures inflation experienced by companies and businesses. And in the 12 months ended August 2005,  as this release shows, the cost of finished goods rose 5.1 percent, while the cost of crude goods rose 11.3 percent.

How does an 11.3 percent rise in the cost of crude goods paid by businesses get translated into a 3.6 percent increase in the cost of goods and services paid by consumers? We’ve got some pretty powerful inflation shock absorbers—companies and industries that manage to keep consumer prices down while experiencing higher costs themselves.

In the ‘90s, information-technology companies such as Cisco, Intel, Dell, and GE acted as inflation absorbers. Their technology cut costs and improved productivity throughout the economy, holding down prices. But such easy gains are gone, and other parts of the economy need to absorb the massive rise in energy and raw-materials costs caused by world events and the growth of China and Japan.

That’s where Wal-Mart comes in. With domestic sales of about $229 billion in 2004, Wal-Mart accounted for about 8.66 percent of the nation’s retail sales (not including cars and car parts). Wal-Mart’s obsession with low prices forces all its competitors to keep their prices low, too, even when the prices of the inputs needed to make products—gas, plastics, steel, and construction materials—are rising. Wal-Mart absorbs inflation shocks by adhering to three disciplines. First, it buys aggressively from low-cost China—to the tune of $18 billion last year. Second, it continually beats up its 61,000 U.S. suppliers (with which it spent $150 billion in 2004) to produce at lower costs and accept lower profit margins. Third, it accepts low margins for itself. Wal-Mart’s operating income is generally about 6 percent of sales. Shoppers may like it. But shareholders haven’t been thrilled. Indeed, the company’s stock recently slumped to a five-year low.

The companies that make shock absorbers have also proved to be major inflation shock absorbers. The biggest single sector of the U.S. retail market is motor vehicle and parts dealers, with a whopping $882 billion in sales in 2004. For the last several years, U.S. automakers have spared no expense or effort to keep their products affordable, even as the cost of steel rose sharply. First came zero-percent financings, then heavy promotional rebates, and, most recently, the extension of employee discounts to all buyers. Stockholders of General Motors, Ford, and Daimler Chrysler have surely absorbed some of the pain associated with keeping prices low in an inflationary environment. But the impact has fallen heaviest on auto-parts suppliers.

Time was, the Big Three used to make many of their own parts. But they ultimately spun off their parts units as more or less independent entities. That way, the auto companies would free themselves of obligations to the parts units’ aging workforces and be in a better position to extract favorable prices. GM spun off Delphi in 1999, and Ford spun off Visteon in 2000.

In the last few years, companies like Visteon and Delphi have been caught in a vise. Auto parts are generally made out of steel and plastics like polypropylene, whose price is correlated with the price of oil. While the parts makers have to buy raw materials at the market price, they’re tied into long-term contracts (some with their former parent companies) that don’t provide significant relief from commodity spikes.

And so 2005 has proved to be an annus horribilis for U.S. car-parts makers, caught between higher raw-material costs and heartless heavyweight customers. Tower Automotive filed for bankruptcy earlier this year. Collins & Aikman, the second-largest auto-parts company in the United States and a big supplier to DaimlerChrysler, filed for bankruptcy protection in May. Danny Hakim of the New York Times reported today that Delphi could file for bankruptcy this week. And Ford recently offered to relieve Visteon’s pain by taking back a chunk of its operations. Ford and General Motors may be struggling to keep their heads above water, but they’re doing it by standing on the shoulders of their submerged auto-parts suppliers.

The problem is that the ability of companies like Wal-Mart and Visteon to buffer consumers from inflation may have reached its capacity. And that may be one reason why inflation is finally filtering into the consumer economy. The Bureau of Labor Statistics reported in September that the Consumer Price Index had risen at a rapid 4.2 percent annual rate in the previous three months. And there’s probably more where that came from. Today’s Institute for Supply Management report showed that the prices paid by all companies—manufacturers and nonmanufacturers—rose rapidly in August. With the shock absorbers having grown thin, we may all be in for an inflation jolt.