Economists say 'pipeline inflation' will fizzle in 2000
By Anne Millen Porter -- Purchasing, 2/10/2000
Last month, buyers reported steadily rising prices in nearly every major industrial commodity segment (see story on page 26). By January 2000, the percentage of buyers reporting generally stable to higher pricing in the prior month had risen to 74% from a low of just 37% twelve months ago (see chart below). What's more, Purchasing detects a dramatic upward shift in buyers' price expectations for the months ahead. For every material category tracked by Purchasing, diffusion indexes following three-month price expectations now stand in excess of 50%. In several categories, these price expectation indexes have climbed to the 60%-70% range.In former years, such reports might have given rise to deep fears about shrinking profits and "pipeline inflation." But this year is different. In fact, a Purchasing poll of professional economists finds most expecting neither profits squeeze nor an inflation surge in 2000.
Cost pressures build...
The experts acknowledge that commodity prices (often referred to as "pipeline inflation" pressures) have intensified recently in the U.S. domestic economy.
Elizabeth Baatz, a cost modeling expert and economist with Thinking Cap Solutions in Port Angeles, Wash., remarks that, "In late-1999, the combination of weak prices and rising costs have been like a boa constrictor squeezing margins in a large number of manufacturing industries." According to the TCS ICE-Alert model, Baatz says, "Some of the industries that we think will be under the greatest pressure to raise prices in order to offset higher costs include manufacturers of glass containers, plastic foam products, industrial gases, synthetic rubber, plastic film and sheet, carbon black, fertilizers, steel, and aluminum sheet."
Andrew Hodge, senior vice president with WEFA, an economic forecasting group based in Eddystone, Pa., says, "We're now seeing temporary upward pressures on goods prices," due to rising input prices (especially energy) and rising import prices.
Anirvan Banerji, co-director of the Economic Cycle Research Institute (ECRI) in New York, notes that the group's U.S. Future Inflation Gauge (USFIG) has turned steeply upward in recent months (see chart on page 23). Underpinning this upturn, he says, are commodity price increases and tightening supply conditions being reported by purchasing professionals around the country (as captured by NAPM's indexes on prices paid and supplier deliveries).
...due to global rebound
The economists attribute the late-1999 commodity price surge, in large part, to the re-synchronization of growth among the world's major economic hubs.
Andrew Szammosszegi, senior research associate with the Washington, D.C.-based Economic Strategy Institute, points out that, "The Asian economies are picking up again, Europe is stronger than it was a year ago, and we still have strong demand in the U.S."
Baatz of TCS observes that, "The U.S. economy continues to grow, and most of the world's economies are all moving in the right direction for the first time in years. Excess capacity that plagued the world in 1997-1998 is now disappearing. Oil prices have turned up and U.S. import prices are rising again. In short, the world economy is on a cyclical rise."
Throughout the 1990s, Banerji of the ECRI notes that there were only two instances--1994 and 1999--when all major world economies were expanding at the same time. In the early 1990s, he says, the "English-speaking" economies were in recession. Then it was continental Europe and Japan. In 1994 (the last time commodity prices were rising rapidly in the U.S.), Banerji notes that all major world economies expanded for a brief period. Then Japan fell back into recession and the Asian crisis followed in 1997. In 1998, he says, the major Asian economies began to recover and Japan followed in 1999. "Japan was the missing piece, " Banerji says. "For most of the decade, global overcapacity allowed the U.S. economy to import and deflation. Now, for the first time since 1994, we have every major economy in the world expanding. This is why bond yields are rising and Fed is moving aggressively to preempt inflation."
...but economists aren't really worried
Still, despite the dangers of synchronized global growth, pipeline price pressures have yet to back the U.S. economy into an inflation corner, according to the experts polled by Purchasing. The major reasons--
- Productivity. "Productivity is the way out," says WEFA's Hodge. "We're seeing big gains in business productivity and even bigger gains in manufacturing and processing sectors."
ECRI's Banerji agrees. "We could talk for hours about how technology innovations are squeezing costs out of the system. Despite not having much power to raise [finished goods] prices, profits have remained largely intact and this will continue to act--in a structural way--against inflation."
David Orr, chief economist with First Union in Charlotte, N.C., says, "To hear manufacturing CEOs tell it, they've only just begun to take costs out of their processes. The people on the firing lines believe they can raise productivity enough to offset cost increases in 2000. Price competition is fierce and they can't afford to let their competitors become more cost-effective."
Szammosszegi of the Economic Strategy Institute says, "It's tough to predict productivity growth, but based on investment levels we've seen, I would imagine that we'd continue to see large gains. A lot depends on the performance of economy as a whole."
- Employment costs. The economists are also generally sanguine on the employment cost front. First Union's Orr cites three reasons why he expects to see continued moderate upward pressure on wages and benefits costs in 2000. One is that more companies are introducing variability into their cost structures by using such things as bonuses and stock options. "This allows them to pay more when times are good and less when they hit a bad patch." Second, there are large numbers of workers in the 50-plus age bracket who fear the technological revolution. "These employees are likely to demand less," Orr says. And third, so long as prices aren't rising, there's less reason to demand higher wages. While continued tight labor markets suggest some upward pressure on wages in 2000, Orr says, "It won't be as strong as some people fear."
Says WEFA's Hodge: "We could see bad first-quarter numbers on the Employment Cost Index (ECI). Unlike 1998, Wall Street will have handed out big year-end bonuses in 1999. Still, that will be temporary."
- The vigilante Fed. The Federal Reserve is another big contributor to economists' collective peace of mind over pipeline cost pressures. The Fed, says ECRI's Banerji, has moved "preemptively and aggressively to head off inflation." Looking back to 1994-1995--the last time all world economies were growing simultaneously--Banerji notes that the Fed hiked interest rates seven times, doubling rates during the period. "This Fed is smart enough to understand that there were pipeline inflation pressures developing in 1994. The economy needed to slow in 1995 because there were no offsetting imported dis-inflationary pressures." Banerji predicts a replay of this activity in 1999-2000. "The Fed has already acted several times, but it's clear their job is not done," he says.
- The fizzle factor. A fourth reason that economists aren't particularly worried about pipeline price pressures is that they simply don't expect them to last. For example, WEFA's Hodge says recent rebounds in both imports and input prices are likely to be short lived. "Prices for many commodities, steel for example, had been pushed to below-cost levels, making them subject to rebound," Hodge says. "But in our view," he adds, "this is not the beginning of an accelerating, sustained trend." Reasons: For many industries, production capacity worldwide remains excessive and investment numbers are still strong. What's more, Hodge says, the advent of e-commerce will only create additional competition for producers in coming years.
Orr of First Union says, "My hunch is that recent commodity price activity will taper off." He classifies recent upward price activity as "re-flation" rather than inflation. "Very few commodity prices are back to where they were in 1997 before the global deflation crisis began. While input costs were falling, few manufacturers lowered prices. This allowed profit margins to rise. Now, manufacturers will have to give back some of what they gained over the past several years."
While anticipating continued increases for basic raw materials in 2000, Orr says "I don't think there's any chance that prices will rise at the pace we've seen in the past six to eight months." Recent increases, he says, have also been exaggerated by what he calls the "rubber band" effect where people--anticipating higher prices--create a buying frenzy that, in turn, reinforces the upward price trend.
Baatz of TCS remarks that, "Many manufacturers have been operating with tight margins for several years and are ready to pounce on any opportunity to raise prices now. The challenge for buyers remains trying to figure out when a price hike may be justified and when it's not. During the dis-inflationary period in 1997-1998, some industries bolstered margins by not lowering prices when costs were falling. So margins today, even as commodity costs rise, may not be under as much pressure as suppliers would like buyers to believe. Each price-hike proposal needs to be investigated for its margin implications."
No worries yet
While economists think the U.S. economy can avoid general inflation and a profits squeeze in 2000, their outlooks generally rely on continuation of the status quo--continued economic expansion, moderate wage growth, continued productivity growth.
"Right now, I'm not all that worried about a profits squeeze, although things could change in a hurry if certain things happen," says ECRI's Banerji. For example, "Any type of crisis in consumer or investor confidence would create a very different situation." Two potential sources of such a crisis: The Fed or the bond market. "It's very difficult to put the brakes on the economy without tipping it into recession. The Fed succeeded once in engineering a soft landing (in 1995), but they succeeded at a time when the economy was not nearly so vulnerable to a decline in stock prices." Outside of Fed control, Banerji thinks that bond yields in excess of 7% could precipitate a stock market decline. "That would be fueled by the perception that the Fed is not able to do enough to head off inflation."
Another danger is that economic growth could slow, drying up the well of growth in productivity. Szammosszegi of the Economic Strategy Institute says, "We could be left with less than stellar productivity numbers if output begins to grow less quickly and companies still have the same numbers of employees on board."
Unexpected wage growth would be another scale tipper. Baatz of TCS suggests that "Wage inflation in the U.S. will likely remain low. However, if the Federal Reserve Board raises interest rates too much, then wages could bounce up rapidly." Szammosszegi says, "If wages rise more than expected, then productivity growth won't matter."
Bottom line, according to Banerji: "We've seen a skillful handling of the economy and a lot of luck during the 1990s. If we continue to have both, we'll be fine."
Bottom line for purchasers, according to Baatz: "I think purchasing managers need to be more analytical and need to track and understand the nuances of how inflation affects their suppliers. It's not enough just to look at the CPI or PPI. They need to know what is happening to price trends and underlying cost trends (and margins) in each of the major industries from which they buy. Buyers that understand industry inflation trends will develop the best negotiation strategies and will be best prepared for both the hazards and opportunities that the changing price landscape presents."
New vs. old economy
While the current combination of strong growth and low inflation in the U.S. economy may be defying the old "laws" of economics, the experts aren't quite ready to abandon their old tenets for forming inflation expectations.
Says Baatz of Thinking Cap Solutions: "The technological revolution has had a dis-inflationary effect on the economy and everyone wants to focus on this. But meanwhile the "old" economy's business cycle is still alive and kicking."
Szammosszegi of the Economic Strategy Institute says, "People think we're in a price constrained environment, so they're not raising prices. This is easy to do in a climate of productivity growth and muted wage demands. But at some point, we have to believe that low unemployment will translate into higher demands for wage increases. The laws of economics have not been repealed. Inflation will increase as long as demand in the economy remains robust. When that happens is anyone's guess."
By now, says ECRI's Banerji, "its been demonstrated conclusively that you can have strong economic growth without inflation--given the right circumstances. Growth and inflation have distinct cycles. Sometimes they are not in sync. This has been one of those times." Still, Banerji notes that, "Bond traders are not acting as if they believe there's a disconnect between economic growth and inflation. Bond yields are going up, suggesting that the market is taking the current inflation threat very seriously. Imported inflation is now reinforcing domestic inflationary pressures. Cyclical forces are now becoming powerful enough to overwhelm the technology gains."
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