BrainTrust Query: OK, it’s official – deflation is a real threat. What now?

Discussion
Nov 21, 2008

By Bill Bittner, President,
BWH Consulting

The consumer price index
had its largest decline since World War II in October. Regulators
are pondering whether they need to step in to prevent a long period of
price declines. How should retailers react?

The dirty little secret
about inflation is that it actually enables retailers to make money on
inventory as prices rise faster than acquisition costs and they sell low
cost inventory at higher retail prices. Now retailers are facing
falling acquisition costs and consumers who are willing to postpone purchases
in the expectation of even lower prices. Retailers must meet these
lower price expectations in order to get consumers to buy, regardless of what
the inventory acquisition cost may have been. Earlier negotiated
wage and rental rates now seem inflated when compared to current commodity
costs. So you have strapped retailers facing lower margins and outsized
labor and rent costs. Not a real pretty picture.

At this point it is still
uncertain whether October was a blip or if we’re headed for a protracted
period of declining prices. But for retailers facing the current
economic climate, there are some key steps that can be taken to reduce
exposure. Inventories must be reduced; it is no longer economical
to carry slow moving items or over allocate shelf space to accommodate
excessive case packs. Carrying safety stock has now become more expensive,
so greater tolerance of out of stocks may make sense in some categories. Retailers
must consider negotiating more aggressive terms for “stock protection” in
order to reduce the impact of cost declines on previous purchases.

Wages are the classic
example of a “sticky downward variable.” It is very difficult
to reduce wages; instead the general reaction is to lay off workers or
reduce employee hours. I have read about past efforts to avoid layoffs
by getting the workforce to accept wage reductions. Those situations are
rare but non-union (and possibly union also) retailers need to start considering
how they are going to handle this. A lot of human resource departments
are going to be busy trying to explain this to employees.

Finally, rents may be
a factor. To some extent, rents based on sales or other performance
requirements may be self-correcting but others will require some negotiation
with owners. The good news is that maintenance costs and possibly
tax rates should be declining. This will provide room for the landlord
to make adjustments.

Discussion Questions:
So, is deflation here to stay? What are some other things retailers
can be doing now to cope? Could wages ever be reduced?

[Author’s
commentary] I tended to emphasize the cost reduction aspects for responding
to deflation, but there is also a revenue aspect. Retailers must
do more to get reluctant shoppers into the store by offering incentives
for them to visit. These could involve emphasizing a few loss-leaders
or some other “too good to miss”
opportunities that attract consumers. It is going to be difficult to
get consumers to make a purchase, so retailers with their own credit card
program may do better. But the credit card carries its own risks as
laid off consumers are unable to keep up with payments. Layaway plans
reduce loss exposure because the merchandise serves as collateral, but layaways
face the same issues as declining inventory values.

Let’s hope
October was a blip.

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14 Comments on "BrainTrust Query: OK, it’s official – deflation is a real threat. What now?"


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Nikki Baird
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Nikki Baird
13 years 5 months ago

Am I the only one who doesn’t get why this is suddenly a problem? I mean I understand the declining revenue thing, but didn’t we just have an almost unprecedented run-up of commodity prices in the last year? Was oil not at almost $150/barrel six months ago? Was everyone not bemoaning the fact that food and gas price INflation was destroying the amount of disposable income that consumers had to spend? That the lowest income consumers were getting crushed under these prices?

Does it not make sense that when some of the underlying costs of these commodities (like, for example, OIL) fall by more than half, that the prices of the finished goods will also fall? Why is this a surprise? Or a catastrophe?

Lisa Bradner
Guest
Lisa Bradner
13 years 5 months ago
Bill, I’m absolutely not an economist but I believe the huge drop in October was precisely related to the huge increase in oil prices (and therefore the cost of shipping and delivering commodities) that drove up everyone’s cost of doing business. I think FDR had it right with his “we have nothing to fear but fear itself.” The market seems completely irrational now and we do risk that consumers will stay away because of fear rather than from a true inability to spend–So, is October a blip? Yes, I think it is. Media loves to play games with percentages but we need to remember how quickly things shot up in the first place. Your points are all good ones but since retailers had a short period of time when they were buying goods at “oil inflated” prices I’m thinking it should steady itself out fairly quickly as well. The bigger concern I have–retail has been propped up for years by people putting more on their credit cards than they could actually afford. What happens if… Read more »
Doron Levy
Guest
Doron Levy
13 years 5 months ago

The best short-term strategy at the store level is to build bigger baskets. As margins erode, the obvious solution is to make it up in volume. We can do that at the store level by increasing the number of items each customer buys thus building a bigger basket. My directive to my clients right now is to seriously increase the level of customer service and presence on the sales floor. Simple things like taking the customer directly to the location of the product they are looking for and actually putting it in their hands or buggy will go a long way in building a bigger basket. Don’t forget recommending associative products on the sales floor and cash (this is the reason I don’t like self-serve tills). How many extra batteries can you sell if your cashier suggests it to everyone who passes through his or her till? It’s all up to us field personnel right now to get us through this rocky season.

Lee Peterson
Guest
13 years 5 months ago

This is new? We’ve had Walmart lowering retail prices for 30 years, so now that everyone HAS to compete with them, it becomes an economic issue? Seems like if it was a real concern, we should’ve done something about it (like what?) a long time ago. The writing’s been on the wall.

The real issue has always been stagnant wages. Huge discount players and poor lending habits have offset the blow of lower wages and made the average person feel as if they’re moving up the ladder. But in reality, that’s not been the case. Now, lower prices are a necessity.

But so, btw, are higher wages. Call it Socialism or whatever you want, but until we create REAL wealth for the middle class, deflation will prevail (as it has now for 30 years).

Liz Crawford
Guest
13 years 5 months ago
I agree with Doron–bigger baskets are key, now. (Maybe easier said than done.) However, I am concerned about the permanent–or at least lasting–effects of consumers’ behavior and expectations. Deflation as well as bargain hunting, online price comparison shopping and extensive couponing may change the price/value relationship of goods. This is why I believe that encouraging larger baskets, perhaps using loss leaders as a lure, could help in both the short term and the long term. Get consumers used to the idea that a good overall deal can be had at your retailer. In the short run, the extra volume will help with skinnier margins. When the economy comes back (God willing), then consumers will be happy to not spend the extra time and effort to shop all over town to save $1.00 on a pound of coffee. How to do this? Loyalty cards may be part of the answer. Grocers in particular are climbing up the learning curve of sophistication here. For example, fuel perks. Getting consumers to buy into the retail franchise as “members”… Read more »
Gene Detroyer
Guest
13 years 5 months ago
Doron is right on target. In reference to the commentaries of just a few days ago with regard to systems to speed up cashiers and another to make returns more difficult, the BrainTrust was pretty much in step that in hard times, you increase your service, not decrease it. You make your retail destination a preferred destination and ultimately you sell more. You make the customers’ experience comfortable and you extend the time spent in the store and ultimately you will sell more. With regard to deflation, October’s drop in the CPI was driven by the drop in oil. Today oil is at 1/3 of what it was just months ago. But deflation looms on the horizon. We have seen this in various industries before, particularly in the airlines, when unions have agreed to wage cuts. But the more likely and more real decline in wages will be as the economy goes through the upheaval of wage earners changing jobs. Auto workers may not experience a cut in wages, but those workers who are laid… Read more »
Ed Dennis
Guest
Ed Dennis
13 years 5 months ago

Deflation could be a Godsend. Ask yourself how much the buying power of your savings and 401K have decreased in the last 6 months.

If my buying power is decreasing, doesn’t it make sense that deflation will be a byproduct? What is a merchant going to do with inventory that no one can afford? You better find a way to liquidate it and get new inventory at a lower price. And who is deflation threatening? Deflation threatens anyone with inventory.

Commodity prices have been falling, home prices are going down. It’s a cycle and we are still heading down and deflation is a flush additive. Deflation will re-balance the economy and to some extent, restore the buying power of the dollar. Are people going to get hurt? Yes they are.

Don Delzell
Guest
Don Delzell
13 years 5 months ago

I am NOT convinced that deflation is here and is a fact. Although I am absolutely NOT an economist, I am keenly aware of the cost impact the price of oil had across the retail product supply chain. Those of us in the trenches know that it wasn’t just the raw materials or even the finished goods prices for products dependent on petro-chemical feedstocks (plastics). Freight went up, and up and up. Remember the gas premium attached to shipping charges? All of those were hidden costs that occurred even before the “shock” itself set in at the gas pump.

The data on deflation being real DID control for auto and gas prices….but it did NOT control for the hidden cost adjustments noted above. There is absolutely no reason I can see why deflation would set in. Price adjustments as costs decline….yes…that can and will happen. I’m not a believer.

David Livingston
Guest
13 years 5 months ago

At the fast pace that the Treasury is printing off billions and trillions of dollars to bail out everyone, my guess is deflation is just the news item of today. Tomorrow, after the government has basically handed out thousands of dollars to everyone to bail them out of irresponsible behavior, I believe inflation will be a huge factor in erasing our debts. You can’t just wipe out mortgage debt, give away stimulus checks, and provide bailout packages to idle industries without winding up with Banana Republic style inflation. Deflation? It’s the least of my worries.

John Gaffney
Guest
John Gaffney
13 years 5 months ago

I’m with Nikki. I understand the potential problems of deflation, but I think they are old economy problems. It’s a math problem, and math problems aren’t going to help anyone pull out of this mini-depression. What will pull us out is consumer spending. Lower prices, especially on gas, puts money back in pockets. We need to get back to the “buy-sell-profit-repeat” business model. Retailing in that regard is a good solid business. No derivatives. No credit-default swaps.

Retailers should capitalize. Maybe all those desperate discounts can be revisited. Maybe it’s time to pull customers back into the store with loyalty program rewards, sell current inventory, and deal with deflation after the holidays with a stronger hand to play.

Kai Clarke
Guest
13 years 5 months ago

Deflation over an extended period of time is the scourge of retail and will only increase the recessionary impact we are now experiencing. As stores try to compete with more expensive costs for products that are selling for less, their profit margins decrease. This means that companies will report lower earnings, their stock will fall, and companies will have to find other ways to cut costs. Labor costs are usually one of the largest costs in any organization, and this usually means it is the first place to get cut. This results in layoffs, which impact the broader market with fewer people purchasing cars, homes and other items.

M. Jericho Banks PhD
Guest
M. Jericho Banks PhD
13 years 5 months ago

As I understand it, this is a case of asset class deflation vs. dollar devaluation (with help from David Waring at http://www.informedtrades.com). Asset classes include stocks, commodities, manufacturing, housing, and others. During inflationary times, the expanded money supply is pushed into asset classes which increases prices there. Deflation is the free market effort to get rid of so-called “overinvestments” and move the value of money supply back to where it belongs, based on valuations unpredicted on expected future inflation.

What grabbed my attention in this report was that one result of deflation will be a decrease the price of U.S. exports, thus increasing trade in our favor while keeping our factories running. Our balance of payments–historically negative due to oil imports and stuff from China–will not be moved in our favor within the foreseeable future. But, the variable value of our dollar is a key element in our economic recovery.

Ted Hurlbut
Guest
Ted Hurlbut
13 years 5 months ago
Like others here, I’m not an economist. Still, the issue seems to me that we don’t really know exactly what real estate values are, and those assets make up a very large percentage of our total real assets. This has tightened credit and has seriously impacted consumer durables, such as automobiles, and brought their values into question. All of our other recent recessions have seen inflation moderate but not actually turn negative. My understanding is that the truly frightening thing about deflation is that falling asset values feed on themselves, further depressing economic activity, and we don’t really know how to check and reverse that downward cycle. We’ve not had to try to do that before with our current macroeconomic toolkit. We know how to keep inflation in check, but we don’t know for certain that we know how to reverse a deflation. From a retail perspective, we have long experience with retail “deflation”; they’re called promotions, events, and clearance sales. We’ve dealt with it by rationalizing manufacturing and the supply chain to reduce unit… Read more »
Craig Sundstrom
Guest
13 years 5 months ago

Well I AM an Economist (or at at least I used to play one in college) and I agree with those who think we’re getting a little ahead of ourselves when we extrapolate a single months’ data into Great Depression II.

Prices either go up, stay the same, or decline, and lately some Cassandra has never failed to emerge to proclaim the End-of-the-World because one of the three has (allegedly) materialized. Yes, people (and businesses) need to plan ahead and be prepared for various contingencies, but that’s hardly the same as creating a self-fulfilling panic.

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