4 Reasons Rising Prices Are Good News

Modest inflation means the economy is growing, with improving prospects for hiring and raises.

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The rent is going up, but your paycheck isn't. It's hard to offset a rising food bill when your cart is already filled with store brands and bulk items. And the prospect of $4 gas triggers a sense of gloom that makes you want to hide your wallet in a drawer.

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Inflation is on a lot of people's minds, especially since the Federal Reserve and many economists measure inflation in a way that understates the rising costs that many families bear. The Fed focuses on "core" inflation, which excludes food and energy costs, because that gives them the clearest picture of what's happening in businesses and the labor market. But families don't have the option of foregoing food or fuel. So the policymakers guiding the economy seem out of step with the ordinary folks they're supposedly aiming to help.

As painful as rising prices are, however, they can also represent good news if inflation is happening for the right reasons. In a healthy economy, inflation is almost never close to zero. The Fed considers an annual inflation rate of 2 percent or so to be optimal. In the 1990s, when the U.S. economy was robust, inflation averaged 2.8 percent. The super-low inflation of the last two years was mostly the result of panicked consumers who stopped shopping, forcing merchants and producers to offer deep discounts that threatened their solvency. So far this year, inflation has ticked up to about 1.6 percent. Key items like gas, food, health care, and education are going up by more, but those price hikes are offset by flat or falling prices for things like clothing, electronics, furniture, and appliances.

Part of the problem families face is that the things getting more expensive tend to be essential items most people need, while the stuff getting cheaper is easier to do without. So if you forego a new laptop or toaster, that does nothing to make food or gas more affordable. But the bigger problem is stagnant pay. By one measure, average pay is rising at just 1.1 percent per year, or half a percentage point less than inflation. So the typical family really is falling behind, in terms of what it can buy with the money it has.

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That gap between prices and pay depresses consumer confidence. It also masks the fact that rising prices can be a good thing, especially after a grueling recession like we've just been through. Here are four reasons why:

Rising prices reflect a growing economy. Prices typically rise for one of two reasons: Either there's a sudden shortage of supply, or demand goes up. Supply shocks—like a disruption in the flow of oil from Libya—are usually bad news, because prices rise with no corresponding increase in economic activity. That's like a tax that takes money out of people's pockets without providing any benefit in return. But when prices rise because demand increases, that means consumers are spending more money, economic activity is picking up, and hiring is likely to increase.

There are some legitimate concerns about oil shocks, speculative bubbles, and weathered-out crops, but many of the price increases occurring now are happening for the right reason. "Commodity price increases—including food—are mostly coming from demand," says Jonathan Golub, chief U.S. equity strategist for investment bank UBS. The higher cost of staple foods, energy, minerals, and other materials is raising the cost of Starbucks coffee, Nike sneakers, McDonald's cheeseburgers, cotton shirts at many retailers, and a variety of other items. That's a modest hit for consumers. But rising demand for most of those things means that sales will go up, too, which is what most companies need to see before they start hiring again.

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The right kind of inflation can lift stock prices, too. "Most people assume that when inflation goes up, stocks fall," says Maury Harris, UBS's chief economist. "That's a bad conclusion. For at least a decade, the relationship has gone the opposite way." That's because modest inflation allows companies to raise prices, increase revenue, and spend and invest more. The trick, of course, is achieving the right balance between rising prices and economic growth, which some worry could get out of hand if the Fed fails to rein in the money it has effectively been printing since 2009. That's one reason stock markets will probably remain volatile, even though many analysts expect gains of 10 percent or so through the end of 2011.

They lead to pay hikes. When there's a glut of workers—as there is now in many industries—pay stagnates or declines. It takes robust hiring to sop up excesses in the labor supply and change the equation in workers' favor. Right now, the low cost of labor is the main thing keeping overall inflation in check, since labor, not materials, is often the biggest cost in the production of a shirt or a loaf of bread. So a small hike in the retail price of a good is often enough to cover a big rise in the cost of commodities. If those price hikes, plus rising demand, boost revenue and profitability, companies will hire more, slack in the labor market will tighten, and pay will rise. It's an indirect relationship and it may take a frustratingly long time for benefits to trickle through to workers, but it will be even harder for workers with fixed skills to earn more if prices don't go up.

[See why $4 gas need not wreck your budget.]

Inflation is better than deflation. A year ago, overall prices were falling and economists were worried about deflation, which is a much worse problem than inflation. A widespread decline in prices might sound like a break for consumers, but it's actually quite pernicious. Consumers put off buying stuff until they can't do without it, because they know everything will be cheaper in the future. That cuts consumer spending and hampers growth indefinitely. As prices fall, so does income. Debts like mortgages and car loans become more expensive over time, since they must be paid in fixed amounts that take up an increasing amount of take-home pay. That makes consumers and investors loath to borrow, which depresses the economy even more.

Japan has been the poster child for deflation over the last two decades, with an intractable cycle of falling prices that turned a vibrant economy into a stagnant one. That's one problem we seem to have avoided.

Rising prices could help end the housing bust. The housing sector is the most damaged part of the economy, with a painful period of plunging home values now in its fifth year. Homeowners have lost trillions in home equity, and the depressed construction industry accounts for many of the nation's long-term unemployed. In one sense, it's remarkable that the economy isn't in far worse shape, because a sharp pickup in housing is usually what jump-starts a recovery. Not this time.

[See how buying a home is likely to change.]

The first sign of good news for the housing market may be a rise in rents. Increases have been modest so far, but it's notable that rents have been going up at all, given the sharp downturn in housing overall. It's happening because more people are bailing out of homes they can't afford, and because young people who had been doubling up with friends or parents to save money are now getting jobs and setting up house on their own. The migration to rental units is likely to push vacancies down to prerecession levels, which ought to push average rents up by about 3.4 percent this year, according to real-estate research firm REIS. In a few markets, like parts of Washington, D.C., and New York City, rents may even rise by 10 percent or more.

On average, rents will probably rise by more than overall inflation, and by more than incomes as well. But that's the kind of pressure that could eventually make purchasing a home seem like a bargain and help lift sales from abysmal levels. The shakeout won't necessarily be comfortable or orderly, since not every renter will be able to muster a down payment or qualify for a mortgage. But many of the people paying higher rents, according to REIS, will be young workers between the ages of 25 and 34—in other words, the future home buyers of America. Like their parents, they're likely to migrate from rental units to their own homes at some point, and the faster rents rise, the sooner they'll jump. And when fresh buyers finally push home prices up again, that will be one bit of inflation nobody's likely to complain about.

Twitter: @rickjnewman