Don't sound the alarm on inflation yet, but be wary

I have heard the word "transitory" more times in the past few weeks than I care to count. It has recently become one of the most uttered and analyzed terms in the field of economics. If I were selling ice cream, I would call it the flavor of the month.

My problem with this particular adjective is that many economists, high-level policymakers and politicians insist on using it repeatedly to describe the sharp increase in the rate of inflation in the U.S. this year. And just to be clear, I cannot say with any certainty that they are wrong. The current spate of higher-than-expected readings in the inflation data may ultimately prove to be merely transitory.

Nevertheless, these explanations have reached a level where the more I hear somebody using this word, the more it sounds to me like a sales pitch rather than a forecast. I am not yet alarmed, so I do not want to sound the alarm. But I cannot ignore the fact that we have never experienced an economic recovery like this one before. So while the folks at the microphones continue to project a posture of certitude, I prefer to stay wary.

I am not alone in my skepticism. Plastics processors have witnessed a wide variety of outcomes stemming from the onset of the pandemic and the subsequent recovery. Some have enjoyed surging demand while others have suffered sharp declines in business activity. But most all of them are facing the same two prevailing market forces at the moment: a sharp increase in materials prices and rising pressure on wages. And the plastics industry is not unique. These forces currently impact a wide swath of the entire U.S. economy.

There are a number of different ways to measure inflation, which, by the way, is a big part of the problem. The most commonly cited measure is the Consumer Price Index, or CPI, for short. For the 12 months ending in May, the core CPI escalated by about 4 percent. The data used to calculate the core CPI excludes changes in the prices of the volatile categories of food and energy products. There is no doubt a change in food prices can affect demand for certain plastics packaging products, so you may argue that food and energy should not be excluded. But most of the time, price changes for food and energy products are due primarily to transitory factors, so most analysts choose to focus on the so-called core data.

A 4 percent rate of inflation over the past year is not too bad, all things considered. But if you take a closer look at the numbers from April and May, you discover the slope of the line in the second quarter has increased to an annualized pace of just over 8 percent. In other words, the upward trend in the data is accelerating, and it is currently running at a pace much higher than anybody wants. Now it may slow down in the second half of the year … but there is also a chance it may speed up.

A pace of 8 percent per year in the rate of inflation is certainly closer to what many plastics processors are experiencing at the moment than is 4 percent. There has been a much greater increase than 8 percent in resin prices in recent months, and many processors also report a strong rise in wages paid for new hires. The trend in resin prices correlates closely with the trend in the price of crude oil, and as I mentioned, the price of crude oil is excluded from core CPI data. I am not surprised that the impact on the plastics industry has been substantially greater than on some other sectors of the economy.

When materials prices and wages change so much in such a short amount of time, business owners and managers start to worry about profit margins. When the data starts to surprise people, and when the trends start to change at a pace that exceeds expectations, it adds an element of risk that must be assessed and managed. For many business owners, the natural response to uncertainty is to slow down hiring and investment plans.

But is this recent round of inflationary data really a surprise? To be fair, we fully anticipated there would be a surge in consumer demand as the recovery gained momentum, and we knew this surge would be fueled by all of the fiscal stimulus Congress injected into the economy. We also anticipated there would be some glitches and delays in the supply chain as it recovered and ramped up.

We correctly anticipated these things would happen, so isn't it reasonable to believe the forces of supply and demand will eventually catch up and the rate of inflation will return to an acceptable level? This means it will be transitory. Or does it?

At the risk of oversimplifying a very complicated and inadequately understood relationship, I will offer the following guidance for the near term: I believe the supply and demand imbalances that have caused the recent surge in resins prices will eventually be resolved, and therefore resins prices will soon stabilize and then start a downward trend. I am not sure how long this will take, but I do believe this is a transitory situation.

I am less confident about the transitory status of rising wages. Some of the recent trends in the labor market have taken everybody by surprise. There are a lot of open jobs at the moment, and many employers are struggling to fill them. To my knowledge, nobody predicted that a labor shortage would be a problem coming out of the pandemic.

The natural market response is to raise wages. But will this spark an upward wage-price spiral? Economists have never had a clear understanding of the relationship between prices and wages and the causes of a sustained acceleration in inflation. There is a clear cyclical pattern in the historical prices for resins. Prices go up and they come down. However, there is no such cyclical pattern in the data for wages. Once a market price for wages has been established, it tends to be persistent.

Policymakers may ultimately be able to keep inflation under control, but the risks are rising. Excessive inflation means higher interest rates, and higher interest rates would impede the recovery.