Why higher prices are here to stay

That slow growth has left companies scrambling to keep consumers buying. Discounts, rebates and price cuts are the rule at a time like this, as companies try to keep factories, stores and restaurants busy. The last thing a company wants at a time like this is to lose market share. Companies know from bitter experience that once you've lost market share, it's incredibly hard to win it back. Just ask Motorola (MOT, news, msgs) or any U.S. carmaker.

In many industries, price wars have broken out as competitors fight to keep market share or to expand their slice of the pie. So turn on your TV and you'll see McDonald's touting its value menu with its $1 McChicken sandwich and $1 Double Cheeseburger, and Taco Bell and Kentucky Fried Chicken, both units of Yum Brands (YUM, news, msgs), countering with the 89-cent Cheesy Double Beef Burrito and the 99-cent KFC Snacker, respectively. Yum's Pizza Hut division is in a race with Domino's to see which can sell more pizzas for $5.

That kind of price cutting may preserve -- or even grab -- market share in a slow-growing U.S. economy, but it plays havoc with company margins because the fast-growing global economy has sent commodity prices soaring. McDonald's and Yum Brands have a lot of clout in the marketplace, and that lets them negotiate the lowest prices for their ingredients, but these companies can't pass along their full costs to customers.

McDonald's CEO Jim Skinner said as much in late May. McDonald's will absorb some of the higher costs of ingredients, Skinner said. "This is not the time to be passing that on to consumers. They have long memories."

And this squeeze is happening across the restaurant industry. Most restaurant companies don't have the clout and the scale to control costs as effectively as a McDonald's, so in April menu prices across the industry rose 4.1%, according to Cowen, an investment banking company. That still wasn't enough to offset a rise of 6.2% in food costs, which make up about 42% of restaurant expenses.

Cowen forecasts that food cost inflation will gradually decline in 2008, going from 6.2% in April to 5.1% in the third quarter of the year and to 1.9% in the fourth quarter. Menu inflation rates, strikingly, won't fall nearly as much. Menu price inflation is expected to stay at 4.1% in the second quarter, drop to 4.0% in the third quarter and finish the year at 3.8%.

Another reason prices will stick

I've given you a couple of general reasons why prices should be so sticky to the upside earlier in this column. Now let me give you one more: If a company is eating part of its own increased costs rather than passing them on to its customers, then, in an effort to restore its profit margins, it's likely to keep its prices high even when its costs drop. If the only way to keep a McChicken at $1 when commodity prices were soaring was to cut the profit margin on the product by, say, 5 percentage points (McDonald's gross margin across the company is 35.3%), then when commodity prices ease, the company will keep the price at $1 and work to restore its margins.

The squeeze on companies is bad enough when they operate in just the U.S. market. But it's an absolute killer if you're a U.S. company and some of your competitors are overseas companies that, because they have government support, don't have to worry too much about profits.

That dynamic also helped keep gasoline prices rising even as crude prices fell. With an increasing amount of U.S. gasoline consumption being met by gasoline imports, U.S. refiners now operate in a global market. With demand in the U.S. down slightly and global gasoline refinery capacity rising, U.S. refiners found it hard to raise prices to fully compensate for the higher costs of crude oil. (I know that's hard to believe from retail gasoline prices, but recent price increases could actually have been worse.)

Continued: Costs to refiners

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