Why Gas and Food Prices Are Likely to Drop

Inflation could be a lot less painful by the end of the year.

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It's been an unwelcome hardship at the wrong time. Just as the economy has turned the corner and consumers have begun to dig themselves out, price hikes for gas, food, and other key products have taken the air out of the so-called recovery. But there's good reason to think that those demoralizing price spikes may be temporary, with moderating inflation giving consumers a second wind by later this year.

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Inflation has been an undeniable problem for a lot of families in 2011. As every motorist knows, gas prices have jumped by about 30 percent this year, with the average pump price perched just beneath the unnerving $4 threshold. Food prices have risen by about 6 percent over the last 12 months, with some everyday items, like beef, coffee, and butter up by more. Spikes in the price of certain commodities, like copper, cotton, and rubber, are raising the cost of products ranging from clothes to cars, with manufacturers increasingly trying to pass the pain on to consumers. The sting wouldn't feel so sharp if wages were rising at a healthy clip. But many families are getting by on flat or even falling incomes. So even modest inflation hurts.

Inflation has become controversial because economists measure it in ways that can be strikingly different from the ways consumers feel it. Overall inflation, at about 2.7 percent, is still low, and "core" inflation, which excludes volatile food and energy prices, is just 1.2 percent. That's so low that the inflation police at the Federal Reserve would like to push it a bit higher, to eliminate the risk of deflation, which is usually worse than inflation. The problem for many consumers is they're far more dependent on things getting more expensive than on things getting cheaper. Homes, furniture, appliances, iPads, and most electronics are falling in price, for example, which is a nice break for people who can afford those things. But families on the edge spend more of their income on food, gas, rent, and healthcare, the very things getting more expensive. So when a lot of people hear that core inflation is low, they wonder what they're smoking at the Fed.

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Consumers may soon start to see it the economists' way, however. Forecasting firm IHS Global Insight, for example, expects inflation to flatten out by the end of the year, with notable declines in the price of things consumers notice most: gas and food. Plenty could happen to derail that forecast, and there's still reason to worry about longer-term inflation triggered by the Fed's aggressive efforts to pump money into the economy. But there are also several reasons consumers are likely to get a break from inflation. Here's the outlook for some of the key things consumers spend money on:

Gas. It's always hard to isolate the exact factors driving oil and gas prices up or down, but it seems clear that unrest in the Middle East, disruptions to the supply of oil produced by Libya, and growing demand for oil throughout the world explain most of the spike in prices this year. But part of the rise is also due to a "fear premium" driven by worries that unrest could spread to a big oil producer like Saudi Arabia. If that fear doesn't materialize, prices should drop, which may already be happening. Oil prices peaked at about $113 per barrel in late April, but have since fallen closer to $100. That could reduce gas prices by early summer. IHS predicts that oil prices will level out at about $104 this year and next, barring any more unforeseen turmoil in the oil states. That could bring gas prices back to $3.60 or so—hardly a free ride for drivers, but a lot better than the $5 gas some scaremongers have been predicting. Heating fuel would probably fall by about the same amount.

Other factors could push gas prices down even if oil prices stay fairly high. Energy-research firm ESAI says oil prices above $100 are likely to "erode demand for transport fuels" because businesses and individuals will look for cheaper alternatives to burning gas. A lot of people find it hard to cut back on gas consumption because they have no alternative to driving to work or hauling the kids to soccer practice. But small changes here and there make a difference. Most drivers who trade in a vehicle get one that's more efficient. Businesses continually find ways to shave their fuel costs. In a stutter-step economy like the one we're in, marginal declines in demand can produce enough slack to push prices down. There's also the chance that gasoline refiners, spurred by strong demand for oil, could overproduce gasoline just as buyers are cutting back. ESAI says a "price bubble" for gasoline is already forming, which suggests price declines could follow.

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If motorists do get a break on gas prices, they should be careful not to get complacent. Demand for oil seems nearly certain to rise over the long term, as booming economies like India and China consume more fossil fuels. It's quite possible that $4 or even $5 gas will become the norm. A respite this year might prolong the pain, but smart drivers should get used to conserving and upgrade to a higher-mileage ride every time they trade in their car.

Food. The rise in food prices seems even more temporary than the rise in gas. Energy costs have a lot to do with food costs, because it takes a lot of fuel to harvest, process, and transport food. So if oil prices stabilize or fall, the same thing will happen to food prices. Unusually bad weather in many parts of the world has also led to weak harvests that have driven prices up. And unlike oil, there's a lot of excess capacity in the world for growing food, which is a kind of self-correcting mechanism: As prices rise for certain types of crops, farmers become more inclined to grow them, which adds to supply and helps keep prices in check. IHS predicts that a market correction should bring food inflation down from 6 percent now to about 1.7 percent by the end of the year.

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Housing. There's a silver lining to the epic housing bust that's been underway for five years: Falling prices, plus low interest rates, have made home affordability the best it's been in at least 40 years. The catch for many buyers, of course, is that they can't get loans. And others who might quality for a loan still don't feel good enough about their job security or the overall economy to commit to such a large purchase. If the recovery sticks—which most economists think it will—banks will get less stingy with loans and more consumers will jump into the housing market. In most places, there's enough supply (or oversupply) of homes to keep prices affordable for a long time, even if rates rise. So for some buyers, purchasing a home could be a money saver.

On the other side of that equation are rents, which are rising in many areas because so many former homeowners have become renters, raising demand for a limited supply of properties. Research firm REIS predicts that average rents will rise about 3.4 percent this year, which is more than inflation is likely to be. In a few cities, like New York and Washington D.C., increases could be in the double digits. Since housing is the biggest expense for most people, your personal inflation rate could depend a lot on whether you rent or own, with renters likely to feel much higher inflation than owners.

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Everything else. There's intense debate among economists and professional investors over the long-term implications of the Fed's unprecedented money printing. Some argue that painful inflation is inevitable, since an increase in the amount of money in circulation always drives that value of that money down. But Fed chairman Ben Bernanke insists the Fed can apply the brakes when necessary, and other economists say there are so many other weaknesses in the economy that runaway inflation seems unlikely. At a recent conference sponsored by the nonprofit Milken Institute, economist Nouriel Roubini said his biggest worries are stagnation and deflation. "I don't believe there's a high risk of inflation," he said. "If commodity prices [get too high], that could double-dip the world economy and cause disinflationary pressure."

Stagnant wages are the reason that widespread inflation seems unlikely anytime soon. For all the worry about oil and other commodities, labor accounts for 65 percent of the cost of goods sold in the United States. Prolonged high unemployment means that in most industries, an oversupply of workers will keep a lid on wages, constraining costs down. Plus, no matter how hard manufacturers try to raise prices and pass their own cost increases on to consumers, many times the price hikes simply don't stick. Consumers can be awfully stingy, too.

Twitter: @rickjnewman