By and  on November 19, 2008

WASHINGTON — As if the recession weren’t bad enough, now there’s yet another economic danger rearing its head like a roaring dragon: deflation.

The U.S. Labor Department on Wednesday reported consumer prices fell 1 percent in October, with a 2.2 percent drop in apparel prices. Women’s clothing prices alone fell a seasonally adjusted 2.5 percent last month. Both the overall fall in apparel prices and the decline in women’s prices were the largest declines on record for the month of October.

Apparel has been in a deflationary spiral for several years, said Charles McMillion, president and chief economist at MBG Information Services. Nominal apparel prices are at levels not seen since 1989, and prices have been flat or falling for much of the last 15 years, he said. But the price declines in October were even steeper than usual.

“The big concern for retailers is…when deflation gets its start, and especially when it’s this strong, it is a severe disincentive for consumers to come in and buy,” McMillion said.

If consumers believe they can get items cheaper by waiting a week, they will wait, he said. Retailers are already promoting deep sales, clearance sales and inventory reduction sales at levels typically not seen until after the holidays have passed. That will almost certainly create the impression that waiting will net consumers a better deal, McMillion said.

“The only way retailers are going to capture any business is by slashing prices,” said Richard Yamarone, chief economist at Argus Research Corp. “He who slashes prices the most will reap the greatest amount of business.”

McMillion said, “For a lot of retailers, this is a life-and-death season. A lot of retailers are pulling out all the stops to make sure customers come through their door and not the guy down the mall.”

Given steep declines in comparable-store sales, retailers have been discounting products since early October, either discreetly or not, with 30, 40 and 50 percent off signs now prevalent throughout stores. The falling prices are evident not only on the shop floor, but in retailers’ third-quarter reports to Wall Street.

“We have lowered [the] average regular price by an average of 22 percent on over 800 styles,” Blake Nordstrom, president of Nordstrom Inc., said on a conference call last week. “We want to make sure we have the right price on merchandise up front, rather than take markdowns to clear merchandise. In many cases, this requires that we take lower markups, which we have and will continue to do.”

Not so long ago, retailers were talking about pressure for higher prices from rising labor and raw material costs. Those days now appear gone.

“We don’t expect any inflationary cost increases in 2009, which is much better than our original expectations only six months ago and very good news for our customers,” Myron E. Ullman 3rd, chairman and chief executive officer of J.C. Penney Co. Inc., said last week.

The news from the government in the last two days that record price deflation had set in cast an even larger shadow on apparel companies and their ability to make a profit. However, economists said lower prices could create some purchasing power in the vital holiday selling period. The deflation at retail comes as vendors continue to face higher costs, with at least one — Hanesbrands Inc. — saying it will have to raise domestic prices in the mid-first quarter of 2009 by an average of 4 percent.

That might be easier said than done, as retailers face a consumer seemingly unwilling to spend on few things but necessities. Women’s apparel prices were down 2.2 percent last month compared with October 2007, the Labor Department reported Wednesday, although overall apparel prices rose 0.3 percent year-on-year. And the decline in the overall CPI followed flat results in September and a drop of 0.1 percent in August. The so-called core prices, which exclude the volatile food and energy sectors, dropped 0.1 percent for the month and increased 2.2 percent from October 2007.

On Tuesday, the Producer Price Index also indicated a deflationary trend. Prices for all U.S.-produced goods fell a seasonally adjusted 2.8 percent in October, the largest monthly decline since records started being kept in 1947, driven mostly by precipitous drops in energy costs. Prices dropped 0.4 percent in September and slid 0.9 percent in August. Prices in the core index, which excludes the more volatile food and energy sectors, rose 0.4 percent in October.

Low levels of inflation are a normal aspect of a healthy economy, helping to boost such components as corporate profits, property values and wages. But in a less-predictable deflationary cycle, companies have trouble making forecasts, consumers don’t know the worth of their assets and downward pressure on wages shrinks real and discretionary income.

“You’re getting a whiff of price deflation, as businesses adjust to the loss of household purchasing power to a slackening labor market,” said John Lonski, chief economist at Moody’s Investors Service. “People are more nervous. Retailers have to compensate consumers for high anxiety by cutting prices.” Apparel prices got “clobbered” in October, Lonski added.

“Consumer price inflation has suddenly screeched into reverse, as the recent abrupt slowdown in world economic growth has led to sharp declines in energy costs, while very weak domestic demand is putting downward pressure on retail prices in many key retail channels,” said Brian Bethune, chief U.S. financial economist at HIS Global Insight.

Bethune cited declines in apparel and lodging prices as indicative of weak consumer demand.

The silver lining of falling consumer prices and in particular the falling cost of energy, Lonski said, may be an increase in household purchasing power that could ward off some of the worst of a weak holiday season. It’s unlikely to bring consumer spending levels back up to previous trend levels, “but it ought to mitigate the severity of the unfolding downturn,” he said.

Determining if the economy is in a deflationary cycle depends largely on where you sit, economists said. The larger economy is not in an overall deflationary environment yet, but specific industries like apparel, real estate, cars and electronics face a different reality.

The timing of the current deflationary cycle could help mitigate the overall effect it will have for apparel retailers, said Yamarone.

“You have a time limit on this and that is Christmas,” he said. “This all has to be done by Christmas. I think the one thing that retailers do have in their favor is the majority of these purchases have to be made prior to Dec. 25.”

Retailers can expect to face a reluctant consumer after the holiday season, too.

Looking beyond a weak fourth quarter, debt watchdog Fitch Ratings projected personal consumption expenditures would fall 1.6 percent next year, the worst decline since World War II.

“Comparable-store sales growth for operators selling clothing, home-related goods and other discretionary categories is expected to continue to be negative,” the rating agency said. “Those companies that have built a strong value perception and have strong private and exclusive brand offerings will outperform their peers.”

Fitch said retailers would continue to conserve cash next year and that the market would force further consolidation among chains.

Any tendency toward a deflationary cycle could also evaporate by next year as the steps taken to address the financial crisis start to have an impact on the larger economy, economists said. But inflation won’t be a problem for policy makers, said Moody’s Lonski. As inflationary fears recede, it should clear the way for any plans the Federal Reserve could have to cut interest rates and Congress won’t be scared off from implementing any future economic recovery plans, he said.

“The inflation threat has disappeared from the radar screen,” said economist Bethune. “Indeed, we expect to see another sharp decline in top-level consumer prices in November and that is providing the Federal Reserve full latitude to move rates lower in order to combat the recession, as well as the ongoing financial crisis.”

Some economists feel that as prices fall, squeezing profit margins and forcing retailers to count every penny, commodity pricing might finally find its way to fashion.

“That sweater is no different than a can of green beans,” said Chris Goodin, principal in Deloitte Consulting LLP’s consumer business industry group.

Goodin said the economic slowdown could force a move to pricing and ordering practices that are more scientifically driven.

“As we come out of this, consumers are going to be harder to predict,” Goodin said. “That’s going to force more price suppression and competitiveness in the market, particularly in fashion apparel, and that’s going to affect the whole value chain.”

Vendors and retailers have taken some stabs at more sophisticated pricing models, but the tendency in fashion to rely on instinct and trends, along with the panic that is being felt in the industry, could derail any such efforts.

“Everybody’s taking pretty dramatic measures that have never been seen before in trying to get the cost back [from suppliers],” said David Bassuk, managing director in the retail practice at AlixPartners LLP.

These steps include retroactive price reductions on previous orders, markdown money and, in some cases, the outright cancellation of orders. For stores, discounts and givebacks from suppliers are all that could save the fourth quarter.

“It’s going to be the difference between those who have better profits over the holiday season and those who are a complete disaster,” Bassuk said.

Arm twisting to make fourth-quarter numbers, though, could also strain vendor-retailer relations.

“Some of those strategic partnerships have been aimed at driving out cost throughout the supply chain,” Bassuk said. “We’re going to see some retailers looking for savings and vendors saying, ‘We already gave them to you because you’re our partner.’ We’re going to see probably some of the partnerships falling apart and the relationships being broken.”

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