Market outlook: Get used to higher inflation, interest rates

According to the Consumer Price Index, the overall pace of inflation in the U.S. moderated in July. The decline was modest, but it was better than many analysts expected.

When compared with the same month last year, the headline inflation rate slipped to 8.5 percent in July. This was particularly welcome news considering that the headline rate for the previous month came in at a 40-year high of 9.1 percent.

Inflation is still way too high, but maybe we can finally state that it has peaked and is now starting to head in the right direction. Falling energy prices were the biggest contributors to the deceleration in the headline number. We already know that energy prices have continued to decline so far in August, so there is good reason to expect that the June figure was indeed the peak for this cycle.

It is no surprise that this data gets sliced and diced in numerous ways. Some analysts prefer to strip out the food and energy components and focus on what is referred to as "core" inflation. It is worth noting that while the energy component declined sharply in July, the food component posted another increase and is now up 11 percent over last year.

There is also another measure of inflation, the Personal Consumption Expenditures Price Index, which some analysts believe is the preferred inflation indicator for the Fed. For the record, the core rate for the CPI was 5.9 percent year over year, and the PCE Price Index for July will not be released until Aug. 26.

I usually focus on the headline CPI number. I consider the food and energy components to be the most visible to consumers, and therefore they are the most important to the surveys that gauge consumers' inflation expectations. Most of the time these surveys are not relevant to the economic outlook, but it is my opinion that inflation expectations from both the consumer and business sectors have been a factor in spending and investment patterns this summer.

It is important that the headline number starts to show some improvement because that will help to assuage some of the anxiety that consumers are feeling when they go to the grocery store. But it will not eliminate the anxiety completely. That's because wage growth is still not keeping pace with the large price increases of the past year.

To illustrate this situation, I have updated my chart that compares changes in CPI to changes in wages.

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We may not have fully appreciated it at the time, but the trends in this data were pretty reliable before the pandemic hit. Inflation was stable right at the 2 percent level, and wages were growing at a moderately faster pace. In theory, this type of growth does not disrupt the relationship between wages and inflation because the gradual rise in the economy's productivity levels keeps a ceiling on prices and a floor under wages.

Obviously, the pandemic disrupted the beautiful state of equilibrium, and this resulted in a self-reinforcing upward spiral in both wages and inflation. Wages increased in July, and they are currently rising at a pace that exceeds 5 percent per year. But when you adjust this for inflation, it means that wages actually declined by 3 percent in the past year.

The impact of all of these trends on the plastics industry has been mixed, but I expect this situation will continue to be fluid. Manufacturers are certainly feeling the pressure to raise payrolls. And since resin prices are closely tied to energy prices, plastics processors have had to endure a sharp rise in the price of materials.

So far, a sizable segment of the industry has been able to maintain their margins by passing these increased costs on to consumers. The supply disruptions caused by the pandemic resulted in a large amount of pent-up demand for many types of products such as building materials, and this demand was amplified by the excess funds created by the government stimulus checks. Higher prices, aka inflation, were inevitable. But they are not sustainable, and neither are the current profit levels.

We clearly need to get back to our pre-pandemic groove, and the Fed is aggressively hiking interest rates in an effort to take us there. Everybody expects them to raise rates again after their next scheduled meeting in September, and I predict there will be some esoteric debate in the interim over whether the next increase should be 50 or 75 basis points. But that is all academic at this point.

So here is my outlook for inflation going forward.

First, I expect that it is going to be higher for longer than expected. These curves have not yet peaked, and once they do, the decline will need to be managed carefully. We do not want a precipitous drop in prices because that would indicate a collapse in demand. We must learn to get comfortable with uncomfortably high prices for the foreseeable future.

Second, the Fed will need to raise interest rates higher than what is currently being discussed in the mainstream media if they really want to get inflation back to a level of 2 percent. History has shown that a Fed Funds Rate in the range of 3 percent is not sufficient to tame an inflation rate in excess of 8 percent.

Interest rates need to be higher than the prevailing rate of inflation if we want to keep inflation low. In other words, real (adjusted for inflation) interest rates need to be positive. They do not need to be positive by a wide margin, but in an economy that is healthy and thriving, real interest rates must be positive. That is not the situation at the present time, so there is still work to be done.

Finally, the Inflation Reduction Act of 2022, signed into law Aug. 16 and which will undoubtedly be signed into law before the upcoming election, will not have any noticeable effect on inflation in the near term, if at all. It may turn out to have a huge impact on the economy in the future, good or bad, and it may also have a huge impact on the plastics industry. But I think the name "Inflation Reduction Act" is more of a public relations gimmick than an actual solution to our current situation.