Deflation: The Grinch that Stole Holiday Food Shopping

The holiday season usually sets food retailers' hearts fluttering like a child's on Christmas Eve. These months often mean the difference between a good year and a great one. This year, however, the industry is facing a Grinch that promises to steal more than just stockings: deflation.

We're in the midst of one of the longest periods of food price deflation in more than 50 years. USDA reports that the consumer price index has been negative on a year-over-year basis since December 2015, causing severe pressure on same-store sales growth. Retail beef prices have declined in some areas by nearly 8 percent, with pork and poultry on a similar (but slightly less steep) downward trend. USDA predicts we could see up to a 19 percent decline in the CPI for eggs in 2016, and the dairy sector is in dire enough straits that USDA Secretary Tom Vilsack has authorized two rounds of government purchases of surplus cheese. It doesn't look like this trend is likely to let up in the near future. According to FMI's 2016 U.S. Food Retailing Industry Speaks, more than half of responding executives foresee further margin compression in the face of low inflation/deflation.

This certainly is not the first time that the industry has had to face declining food prices, but an interesting plot twist this time around is that this deflationary period is taking place during an economic recovery, not during a recession. This is creating some unique winners and losers across the supply chain.

Winner — Consumers

The biggest winners are consumers, who are experiencing lower prices on a host of products. There have been stories around the country of eggs selling for a dollar a dozen and other deals that seem too good to be true. Deflation may be a lump of coal in the stocking of retailers, but consumers are going to walk out of stores this holiday season with fuller carts and more money in their pockets.

Loser — Retail Margins

This round of deflation has its roots in farm country, but these conditions alone don't fully explain what we're seeing at the consumer level. Farm production only accounts for about 15.9 percent of the average food dollar, and this number decreases as the role of food processing in a finished food increases (see infographic on page 52).

At least part of the increase has to do with an oversaturated and fast-changing market. Operating a grocery business is vastly different than it was a decade ago, with an onslaught of new competitive channels, a cantankerous regulatory environment and the fact that food shopping has become a team sport among households, making it more difficult to pinpoint your customers. Some retailers are pushing prices even lower as a means to drive traffic into their stores. A similar strategy was employed by a number of companies during the 2008-2009 recession, but the market is even larger and more competitive today. The end result is that already tight margins are being decimated.

Winner — Retailers That Can Work With Consumers to Tell a "Savings Story"

Prices have been falling for a relatively short period of time, so consumers are not necessarily giving up their money-saving behaviors just yet—even though they are getting some favorable deals. Retailers are finding that they need to be aggressive in working with consumers to help them take advantage of price savings, especially during the holiday season. For example, food retailers are investing in strategies to help bring shoppers back to the beef category, playing up market trends or persuading customers to "trade up." Retailers who can tell a strong savings story with their customers will clearly emerge from this deflationary period stronger.

Loser — Farm Country

Even as retailers struggle to address the impact of deflation on their margins and the industry as a whole, they cannot afford to ignore the longer-term effects on farm country. A decline in retail beef prices of 5 to 6 percent can mean a decline in cattle prices of three times that amount. Farm income in 2016 is going to be at its lowest point in decades and some operations will not survive. Already, 19 of New Hampshire's 120 dairy farms have closed in recent months. Whenever this period of deflation comes to an end, the supply chain is likely to look different than when it started.

This is undoubtedly a challenging season for food retailers. While some analysts are predicting that the deflationary period will break in early spring, retail margins during our traditional food shopping season will offer less sugarplums and more coal unless consumers put the grocery store on their wish lists. Let's hope that the Grinch of food price deflation doesn't completely steal this holiday season.

For a recent food price deflation webinar FMI and the Food Institute hosted with the U.S. Department of Agriculture Economic Research Service, John Dunham and Associates and SpartanNash, visit www.fmi.org/events-education/webinars