Economic Update - Inflation Pressures Are Under Control

U.S. manufacturers, especially plastics processors and toolmakers, have recently been buffeted by wave after wave of price increases in their raw materials. First there was a spike in crude oil and natural gas prices. This was followed by a jump in prices of gasoline and plastic resins. Then came a sharp hike in the cost of steel and most non-ferrous metals. Just a year ago the trade press was full of articles about the prospects of deflation; now the hot topic is whether or not we are on the verge of a battle with inflation.

There are a number of explanations of just what inflation is and why it is so dangerous to the long-term health of our manufacturing sector and our economy. (I prefer to think of it as "too many dollars chasing too few goods.") But the most important thing to remember is that once inflation starts to accelerate, it creates a self-reinforcing spiral in the economy that generates even more inflation in the future.

This is because consumers and producers change their behavior when they have rational expectations for a consistent rise in the price of goods and services. They tend to spend more and save less because their money will be worth less in the future than it is now. Unfortunately, this change in behavior exacerbates the problem by creating even more inflationary pressures.

To avoid such an outcome, the Federal Reserve Board considers controlling inflation to be its top priority. It will be very aggressive in its actions against any threat of inflation. So if inflation means that there are too many dollars chasing too few goods, the Federal Reserve will intentionally curb demand for goods by raising interest rates. In fact, after three years of keeping interest rates low in order to stimulate demand, it is widely anticipated that the Fed will begin to raise rates slowly in the second half of 2004 as a pre-emptive strike against the possibility of inflation as the economy starts to heat up.

But despite the recent increase in the price of some commodities, and all the subsequent hand-wringing by the analysts, processors should not expect much in the way of further inflation this year. Total inflation in the U.S., as measured by the Consumer Price Index (CPI), will remain under 2% this year.

Over the next 10 years the CPI will average 2.5%, which is just about the same as during the past three years. The chart below shows that prices for raw materials have jumped sharply in the past year, but this trend is now losing momentum and could in all likelihood reverse itself in the second half of 2004. It is worth noting that while the price of crude materials has jumped dramatically in recent months, the trends in prices for intermediate and finished goods have remained steady.

Plastics processors have responded to this recent rise in raw-materials costs in several ways, and those that have survived will soon start to reap the benefits of a decline in prices. Some processors have become more efficient in their use of materials by adopting lean manufacturing techniques or by investing in more productive equipment. Others have outsourced their less efficient processes. And still others have just gutted it out and survived on thinner margins and a line of credit.

Stories of processors in key segments of the plastics industry who have recently been able to pass along some of the increase in their materials costs to their customers are becoming more common. So after three stressful years, market conditions are gradually beginning to improve for plastics processors. Rising economic activity in the U.S. and continuing growth in China will keep prices from falling rapidly. But resins and energy prices will soon stabilize, and should even begin to decline in the second half of this year.

Bill Wood, an independent economist specializing in the plastics industry, heads his own firm, Moutaintop Economics & Research, Inc. in Greenfield, Mass. He may be contacted by e-mail: BillWood@PlasticsEconomics.com