Fed seeks sweet spot between slowing inflation, aiding growth

Inflation is hot. This statement accurately captures not only the recent trend in the data that measures the rate of price increases in the U.S. economy but also it describes the amount of attention this trend is generating among policymakers, business managers and consumers.

The latest Consumer Sentiment Index from the University of Michigan dipped to 68.8 in January, its second-lowest level since 2014. For context, this index averaged 82.9 in the first six months of 2021, but it has averaged only 70.3 in the past six months. The omicron variant was the main reason for the drop last fall, but as we start 2022, the top concern for respondents, especially from lower-income households, is inflation. The percentage of respondents who reported being worse off financially than a year ago is also at its highest level since 2014.

This concern was echoed by the latest Small Business Optimism Index, compiled and reported by the National Federation of Independent Business. The overall index decreased only slightly in January to 97.1, but the single most important business problem for the second month in a row was inflation. Last month, 22 percent of business owners reported that inflation was their top concern. This was unchanged from December, and it was the highest level since 1981. The net percent of owners raising their selling prices, another indicator of inflationary pressures, jumped to 61 percent, the highest reading since 1974.

At their latest meeting, the Federal Reserve Board announced that it would hike short-term interest rates in March. This will be their first hike in three years. The board did not announce the size of the hike, nor did it say how often or how much it would hike rates later this year. There is speculation on Wall Street that the Fed may need to hike rates seven times this year. Last year at this time, the first hikes were not expected until 2023.

In an effort to help you visualize what all of the concern is about, I created a chart that compares the rate of growth in the Consumer Price Index to the rate of growth in hourly wages for workers and nonsupervisory employees. The data for both of these series is compiled and reported monthly by the Bureau of Labor Statistics. This chart illustrates the uncomfortable reality currently facing the Fed, many American households and also many plastics processors. Allow me to offer some explanation.

The blue line is the 12-month rate of growth derived from the monthly CPI data. It represents the amount the CPI has increased over the past year when compared with the previous year. As you can see, inflation hovered at a pace of 2 percent per year for many years prior to COVID. The pandemic was a deflationary force when it first hit in 2020, but inflation accelerated sharply as the recovery unfolded in 2021.

During the past year, overall prices increased by about 3.5 percent when compared with the prior 12 months. But the thing that has everybody on edge at the moment is not the actual 12-month pace, but rather the slope of the line. It is heading up sharply with no peak in sight.

To get some idea of when the blue line will peak, I generated a graph of the three-month rate of growth (red line). It is a mathematical certainty that a three-month line will always hit a peak before a 12-month line. But as you can see, it too is heading up sharply with no sign of peaking.

And finally, I included a 12-month graph from the monthly data for average hourly wages in the U.S. (green line). Sharply rising wages has been an issue for plastics manufacturers for quite a while now. This line was clearly rising before COVID hit, but the events of the past two years have exacerbated the problem. Wages clearly increased faster than overall prices during the past two years, and there is no doubt that wage gains are a main contributor to the high rates of inflation we are currently experiencing.

The chart shows the rate of price increases has started to catch up to wage growth in recent months, and this has caused the recent decline in confidence levels. As long as wage gains exceed overall inflation, then spending patterns will be sustained. But when prices rise rapidly, consumers start to curtail spending because they become nervous about their ability to pay their future bills.

To summarize, the U.S. economy is overheating. The irony of that statement is not lost on me as I write this in the middle of winter and as our nation finally approaches what I hope is the end of a two-year pandemic. But there is no better way to describe the current situation. Workers are quitting their jobs at a record pace because of better opportunities, and in almost every industry there is a labor shortage. This has put strong upward pressure on wages.

Kinks in the supply chain limited the supply of many products for the past year, while at the same time, the U.S. government pumped a huge amount of stimulus into the economy. We have low interest rates, rising wage growth, rising energy prices and a shortage of housing and cars.

The net result is too much money chasing too few goods and services — the classic definition of inflation. So now the Fed will attempt to tamp down economic growth just a bit. The goal is to put the brakes on demand just enough to allow supply to catch up. Whether they will be successful in this effort remains to be seen. For now, I am a neutral observer until I see more evidence of either success or failure.

The labor market is the most crucial factor in the outlook. If inflation starts to moderate after the first quarter and the job market stays strong, then real wage growth will stay positive. This will drive spending growth for the rest of 2022.