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October 30, 2017 02:00 AM

Where are inflation, interest rates and the dollar headed in 2018?

Bill Wood
Economics Editor
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    Bill Wood

    Increasingly, I hear the phrase "synchronous global recovery" bandied about in the business media. Most of the time I am either annoyed or amused by economics jargon, but this is one of those rare times when I am just going to flow with it. That's because the situation that is being called a synchronous global recovery is a really good, but truly rare thing, no matter what you call it.

    True believers in the art and science of economics (like me) spend their whole lives trying to get everything lined up and moving in the right direction. Everybody knows that it almost never works out, and the true believers catch more than their share of flak as a result.

    But as of this moment, it appears that the global economy is moving in the right direction and it is picking up speed. This seems to me to be at least as momentous an occasion as the recent solar eclipse and you don't even need special glasses to enjoy it.

    So as we look forward to 2018, what does a global synchronous recovery mean for manufacturers in the United States? For starters, it means there is no recession on the horizon. Many of the well-established trends such as a low unemployment rate, strong consumer confidence and a higher stock market will likely persist through next year.

    But there are a few trends that will change.

    The rate of inflation will accelerate in 2018. Many talented economists have crashed on the rocks over the past eight years by predicting an imminent increase in the rate of inflation. Some have even gone so far as offering plans to generate more inflation. I have kept my powder dry until now, but I am officially calling for inflation to rise above 2 percent in 2018.

    Rising inflation will affect some of us more than others, but the overall changes will be noticeable to everyone. You will likely have to increase wages and salaries at a faster rate than you have in the past few years, and you will also pay more for materials. But you should be able to pass at least a portion of these cost increases through. Remember that accelerating activity in the marketplace is the reason I am predicting an increase in prices, so the good will outweigh the bad for most of us.

    Another trend that will accelerate is the rise in interest rates. The Fed has consistently indicated that it will raise its Fed Funds Rate at a quicker pace next year. It will also reduce the amount of bonds it purchases — officially referred to as the gradual tapering of quantitative easing. The bond market will follow suit by gradually pushing bond prices lower which means that interest rates will go higher.

    All of these dynamics will produce a modest tightening effect on the market for credit. Manufacturers get nervous when they hear that interest rates are rising, and there are more than a few economists and market analysts who believe that the Fed should slow its roll a bit by keeping interest rates at their current level until there is more evidence of rising inflation.

    My personal opinion is that the Fed is on the right track, and that the long-term benefits of "normalized" interest rates will outweigh the costs. But my real objective here is not to take a position on what I think the Fed should do, but rather opine on what I think they will do. And I think we all better get ready for a gradual rise in interest rates next year.

    And since I am already so far out on the proverbial limb by predicting increases in both inflation and interest rates next year, I might as well go for the trifecta and offer a prediction on the value of the dollar.

    As the chart shows, the value of the dollar hit a cyclical peak at the end of 2016, and it has trended steadily lower through the first three quarters of 2017. The peak at the end of last year ended a two-and-a-half year rise in which the value of the dollar increased by 20 percent when compared with the currencies of our major trading partners.

    The reason for such a strong rise over that period is that we were not in a synchronous global recovery. The U.S. economy was growing, but the economies of many of our major trading partners were in recession. This raised the overall demand for dollars.

    The list of economies that have shown signs of renewed vigor so far in 2017 includes Europe, Japan and Brazil. The currency markets have adjusted accordingly. The value of the dollar is down 8 percent from its cyclical peak, but as the forecasted portion of the graph indicates, I do not expect it to fall any further this year. In fact, I expect that it will rise modestly in the near-term. The global economy is getting stronger, but the driver of that growth is still the United States.

    The importance of exchange rates to the plastics industry varies widely depending on the products you make and the market in which you compete. For some processors, exchange rates are a non-factor. But for those who compete in the global marketplace against global manufacturers, changes in the foreign exchange markets can far outweigh changes in inflation or interest rates.

    One factor that should benefit the entire industry is that resin prices tend to stay lower when the dollar is stronger because there is a strong inverse relationship between the value of the dollar and the price of crude oil. Therefore, I do not expect resins prices to rise substantially from their current levels, but this is one forecast that can change quickly. For this reason, I spend a substantial amount of time analyzing exchange rates, so let me know if you are ever in need of further edification.

    Finally, I should mention that all of this analysis is predicated upon some type of noticeable change in U.S. tax policy in the coming months. In my opinion, the tax code is in dire need of reform for the long-term benefit of the country. However, the economy does not need any short-term fiscal stimulus. But again, my intent here is not to stake out a position in the debate. I only wish to state what I expect to happen, and I think that some kind of legislation that purports to improve the tax situation will get passed.

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