Recent Labor Department releases show food costs declining, while restaurant prices continue to rise, suggesting restaurant operators should enjoy margin expansion in 2009. The Labor Department’s December Producer Price Index (PPI) indicated a reversal in the rise in finished food costs, declining 1.5 percent in December from the prior month, following no change in November.

The most marked changes were for fresh and dry vegetables, which fell 14.9 percent sequentially, after rising 3.8 percent in November. Food costs had been rising steeply, driven in part by rising energy prices and the attendant demand for corn for ethanol, which crowded out land for growing wheat and increased feed costs. For the full year 2008, food costs rose 3.7 percent, following a 7.6 percent jump in 2007.

The drop in food costs follows a string of price increases taken by restaurants in an attempt to keep up with food cost inflation. As food input costs decline, restaurant margins should expand, with some offset from heightened promotional activity.

We expect some lag time in the effects on restaurant operator’s earnings. Commodity hedges purchased by many restaurants will slow the effect of falling costs, and there will likely be a lag in the price decline of some proteins, including beef and chicken, as their feedstock inputs were purchased several months back.

Consumer trade-down to grocery stores is also expected to continue dampening traffic and exacerbating the deleveraging effects of fixed costs on lower sales. Nevertheless, most operators will likely feel margin relief in the second half of 2009.

The benefits of declining costs should run from lower wheat costs for fast casual restaurants to falling steak prices for upscale eateries.