Rising Producer Prices Signal Pressure on Profit Margins

(Bloomberg) -- U.S. manufacturers are struggling with the rapidly rising cost of goods and materials. Don't expect this to translate into higher consumer prices, though. Look instead for tighter profit margins or productivity gains. 

The latest read on manufacturing from the Institute of Supply Management reveals that the long expansion is beginning to strain supply chains. The anecdotal responses are particularly enlightening as firms face strong business conditions yet complain that “[l]abor remains tight and getting tighter” and there are “[s]hortages of trucks and drivers.” In such an environment, it's no wonder that firms also reveal anxiety about tariffs, particularly those on steel. With backlogs of orders growing and supplier delivery times slowing, it's evident that supply chains are simply too tight to easily accommodate the disruptions a trade war would bring. 

ISM's measure of pricing pressure, which has surged in recent months, reveals the impact of strained supply chains on producers' bottom lines while raising concern of an imminent acceleration in consumer price inflation. A chart such as this might help fuel those concerns:

At first glance, it might appear that there's a strong relationship between prices paid by factories and consumer inflation, but a closer look reveals the relationship is quite tenuous. Importantly, note the scale of the inflation axis, the right axis. The range is very tight, spanning from 0.75 percent to 2.5 percent despite the much wider variation in the prices paid index. 

In other words, even when firms face high input prices, those prices are not passed on to consumers in any worrisome way. In fact, the Federal Reserve would likely respond to the inflation rates at even the high end of this range with a yawn if they believe inflation would return to their 2 percent target under the current rate path. 

The lesson is to be very careful when reading two-scale graphs like this one. Check the scale of each axis to see if the relationship is actually meaningful. Or, better yet, consider what happens if the data is presented in a scatter plot like the one below, where the regression line shows that the predicted value of inflation is always below the Fed's 2 percent target even when the ISM measure is at its highs.

There is more to consumer price inflation than just costs to producers, so don't let anyone tell you that the ISM data points to stagflation. That's just not true. Does that mean we shouldn't worry about producer costs? No. Higher producer costs have investment implications even if those costs don't translate directly into faster inflation. 

Those higher costs signal pressure on profit margins. It has been long a concern that margins would eventually take a hit as the economy approached full employment. That day may finally have arrived. The threat to profit margins, rather than the prospect of tighter monetary policy, may be the primary factor restraining equity markets this year.

Also note that the pressure on margins from higher resource costs might prove temporary. Watch for firms to respond to higher costs with efforts to boost productivity. They will search out new suppliers, redesign products, and invest in more efficient and potentially even labor-saving capital equipment. We may find that running “a high-pressure economy” as former Fed Chair Janet Yellen once mused might elicit a supply-side response that would ultimately be positive for both equities and interest rates. Overall, there is a lot to watch for when it comes to higher costs for producers, but the leap to substantially higher inflation isn't one of them. 

To contact the author of this story: Tim Duy at duy@uoregon.edu.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.

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