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Higher inflation brings lower standard of living

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Thursday’s report on consumer inflation helps to confirm what many American households have suspected for months — that rising prices are forcing consumers to lower their standard of living to make ends meet.

U.S. consumer prices shot up faster than expected in July, fueling the biggest year-over-year jump in more than 17 years, according to the latest government data. Prices were 5.6 percent higher in July than they were a year earlier. Energy prices were up 29.3 percent for the year and food costs were 6 percent higher.

Excluding volatile food and energy items, the so-called core CPI rose 0.3 percent in each of June and July, slightly above forecasts for a 0.2 percent gain in July. On a year-over-year basis, core prices rose 2.5 percent in July, slightly more than the 2.4 percent rise that was forecast.

A separate set of data showed just how hard those prices rising are hitting household budgets. After adjusting for inflation, the average weekly paycheck dropped by 0.8 percent in July from June, extending an ongoing slide in real income. That left real earnings 3.1 percent lower in July than they were a year ago.

As the rising price of energy, food and other raw materials cuts into businesses' profits, the companies that make, ship and sell the things consumers buy are beginning to pass those costs along. With households already squeezed, something has to give. But paychecks aren’t keeping up with price increases. Tax rebates helped, but they're largely spent.

That means that as the higher costs of food and energy are passed along in higher prices for services and finished goods, consumers will just have to tighten their belts another notch.

“There’s no doubt that inflation numbers are squeezing standard of living,” said John Ryding, an economist with RDQ Economics. “And that’s even more true abroad in the developed world where food becomes a much higher part of people’s consumption basket.”

The recent pullback in oil prices offers hope those price pressures may be easing. A better-than-expected crop forecast in the U.S. also has helped reverse a sharp run-up in food prices. But global food and energy prices may not have fallen far enough to put the inflation genie back in the bottle. Despite a recent drop of more than 20 percent from this summer’s peak, oil prices are still roughly double last summer’s levels. Grain prices have tumbled from record highs this summer, but they’re still more than double 2006 levels.

As consumer budgets have gotten squeezed, so have corporate profits. Faced with higher shipping costs and pricier plastic, consumer products companies like soft drink maker Dr. Pepper Snapple Group have raised prices — even as sales have fallen. The company said Wednesday that revenues rose 1 percent in the latest quarter after higher prices offset a drop in sales volume.

“With the economy the way it is, a lot of our consumers are now thinking with their wallets,” said Larry Young, CEO of Dr. Pepper Snapple. “Right now, we're just watching the market. We’ve got our prices set. We’re always going to be competitive out there. If we see that we need to go up, we'll be able to act quickly.”

Some companies that haven't yet passed along higher costs are having trouble holding the line. Some 38 percent of small businesses surveyed by the National Federation of Independent Business said they plan to raise their prices in the coming months, according to the trade group’s latest monthly survey.

But it’s not clear just how much more of that inflation “pass through” is still in the pipeline, according to Ryding.

“That is the $64,000 question – except in these inflation days it’s the $64 million question,” he said.

Much of the uncertainty stems from the Federal Reserve’s dual mandate to fight both inflation and recession at the same time. To fight inflation, the Fed typically raises interest rates to slow the economy and cool demand. But with the financial system battered by the bursting of the housing bubble and the ensuing credit meltdown, the Fed has cut short-term rates to 2 percent help those banks rebuild their balance sheets.

By holding interest rates at less than half the inflation rate, the Fed is focused on stabilizing the financial system. The hope is that the ongoing slowdown in the economy will eventually take the pressure off demand for commodities like food and energy – and inflation will subside.

“With the decline in energy prices - and assuming that sticks - that clearly improves the inflation outlook relative to what I was earlier expecting,” Minneapolis Fed president Gary Stern told CNBC Tuesday. “It should lead to some slowing in the future in headline inflation, and that should also be to the good from the point of view from inflation expectations.”

A lot depends on whether consumers and investors view prices hikes as a temporary, one-time event – or whether they begin to assume inflation will remain high. If that happens, investors demand higher interest rates to make up for inflation’s corrosive impact on their investments. In the 1970s, consumers responded to persistent inflation by demanding higher wages. So far, that isn’t happening.

“There remains no evidence sign that wage inflation is responding,” wrote Global Insight economist Nigel Gault in a recent note to clients. “When workers see higher prices now, they do not expect a wage hike but rather a drop in their standard of living.”

With the economy shedding jobs and unemployment rising, it’s a tough time to ask for a raise. That means that – unless your paycheck is growing by 5 percent a year – you’re actually taking a pay cut.

Higher inflation also is cutting incomes for retirees living off their savings, and it’s chipping away at the nest eggs of those who hope to retire some day. Savings invested today in a safe 10-year Treasury note are returning about 4 percent – which becomes less than 3 percent after taxes. Factor in a 5 percent inflation rate, and those T-notes are shrinking by more than 2 percent a year.

During the prolonged inflation of the 1970s, house prices also rose rapidly. But today, consumers’ budgets are also being squeezed by falling equity in their home which, until recently, was a critical source of spending power.

“The housing market is still collapsing and you have a huge excess inventory of housing,” said economist Gary Schilling. “Until they are worked off, (house) prices are going to decline and the home equity that people have depended on in lieu of income growth is going to disappear. So, consumers are going to be under fire.”

Declining spending power is already beginning to show up in the results from the nation’s retailers; sales fell in July as the stimulus impact of the government’s tax rebate checks began to fade. Much of that money was spent to make up for higher prices of basic goods. With those checks gone, households will have to make tougher choices on where to cut back.