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Price squeeze ahead
Latest inflation readings suggest higher prices or thinner profits ahead as business costs rise.
October 18, 2005: 7:24 PM EDT
By Chris Isidore, CNN/Money senior writer
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NEW YORK (CNN/Money) - A price squeeze is coming to America. The question is who gets squeezed ... Corporate America or the consumer?

The government's Producer Price Index report Tuesday showed the highest increases in prices are still far away from the checkout line. But a surge is coming.

Last week's jump in prices paid by consumers was the biggest in 25 years. Yet the jump was less than the rise in the price of finished goods at the wholesale, according to Tuesday's producer price report.

The same report showed the price of intermediate goods is up even more. And the price of crude goods -- raw materials used by businesses -- had a double-digit jump.

This marks the third straight month that wholesale prices as measured by the PPI outpaced retail prices as measured by the Consumer Price Index.

Earlier reports, such as the Institute of Supply Management index, have also shown businesses paying more for the goods they need in the wake of Hurricane Katrina.

The question is what happens next.

Do businesses finally start to pass through the increased costs to consumers? Or will they be forced to swallow the increased costs, trimming the profit margins that investors depend upon?

Some economists say that the report is another warning sign that higher consumer prices are on the horizon for things other than gasoline.

"This raises possibility of a pass through into core inflation," said Drew Matus, senior economist at Lehman Brothers. "While companies can absorb some of the pipeline pressures, the way to do so is productivity gains that we're not seeing anymore."

But some others say they don't see much risk of inflation outside of energy prices due to the fact that consumers will have to cut back on other spending to pay the higher gasoline and heating costs.

"Oil prices going up is not inflationary. Inflation is too much money chasing too few goods," said Robert Brusca of FAO Economics.

In a speech Tuesday, Janet Yellen, president of the Federal Reserve Bank of San Francisco and one of the policymakers at the Fed, suggested that even with the rise in energy prices, it appeared that companies were not able to pass along their cost increases.

"Many of our contacts report that keen competition, coupled with healthy profit margins, is limiting their ability to pass these costs along," she said in a speech in Salt Lake City. She suggested that slower economic growth could be the result of the squeeze.

"Firms feel the bite in narrower profit margins, which may crimp the amount they decide to spend on investment in plant and equipment," she said.

Some economists are looking for a squeeze on corporate profits going forward as businesses are unable to pass along their higher costs.

Jeoff Hall, the chief U.S. economist for Thomson Financial, said that while he expects publicly-held companies to continue to report increased profits in the third quarter and fourth quarter, the squeeze between lack of pricing power on the retail side and rising costs could hit earnings in the first half of 2006.

"We are adjusting to a higher energy cost environment. Yes, it's going to impact earnings, it's going to impact production, it's going to impact hiring."

And while Hall said most public companies will be able to withstand narrower margins, he believes there could be increased business failures from the squeeze, particularly among smaller, less well capitalized companies, particularly small businesses.

"It's getting tough to hang a shingle out there right now and only the strong will survive," he said. "Those that can not pass on higher prices, those that need to absorb it, will require a higher capital base."

Brusca said investors need to be careful about the coming profit squeeze in different sectors of corporate America.

"You have to look carefully at businesses, who has pricing power, who doesn't, who can pass costs along, and who can't," he said.

Hall said there are few sectors outside of energy and home builders that have shown an ability to pass along cost increases. He said apparel, recreation, autos and transportation are all having to swallow higher costs due to competitive pressures.

University of Maryland Professor Peter Morici said even if businesses are able to have the productivity gains they need to avoid a hit to earnings, he's more worried about the higher energy prices coupled with the continued weak pricing power causing a slow down in the U.S. economy.

He argues that the Federal Reserve shouldn't take the recent inflation readings as justification to keep raising interest rates, although he's worried that it will.

"Businesses might ask for more (for consumer goods) but they won't necessarily get it, and then we'll see big discounts for Christmas," said Morici. "This squeeze will slow economic activity. The Fed needs to be very cautious how hard they take the economy downhill because it is already headed in that direction."

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For a look at more details of the September Producer Price Index, click here.

For a look at the latest reading on retail prices, click here.  Top of page

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