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Get Ready For Higher Inflation At Long Last

US inflation as measured by the Consumer Price Index (CPI) has been trending lower since late 2011, despite repeated efforts by the Fed to lift inflation to its 2% target. The Fed somehow believes that we need higher inflation to get the economy going.

While the CPI and other inflation measures have failed to cooperate with the Fed over the last five years, there are growing signs that we may soon get a dose of higher inflation, as I will explain below. Since we won’t get the latest CPI report for September until next Tuesday, we will rely on data through August for purposes of this discussion.

On September 16, the Labor Department reported that the year-over-year headline CPI came in at 1.06%, up from 0.84% the previous month.  However, the year-over-year “Core” CPI (minus food and energy) came in at 2.34% and has been above 2% for most of this year.

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The Fed prefers to gauge inflation by watching the Personal Consumption Expenditures Index (PCE), which is slightly different from the CPI. The headline PCE Index rose 1.0% year-over-year, while the Core PCE rose 1.7%.

Most analysts agree that US inflation has been muted to a large degree by the dramatic plunge in oil prices, which began in mid-2014 when West Texas Intermediate crude prices were above $105 per barrel and culminated early this year at below $30. The plunge in crude was also accompanied by a drop in food prices. But recently that has been changing. Crude oil rose back above $50 a barrel this week.

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There are other indicators signaling higher inflation just ahead. Housing costs, which make up one-third of the CPI, have been rising rapidly over the last year – up 3.4% in the last 12 months.  Medical costs have risen 4.9% in the past year, the fastest increase since 2007. Prescription drugs rise by 10% a year on average. The list goes on and on with prices running at or above the Fed’s 2% target.

Some economists believe that we will need to see much higher growth in wages before inflation accelerates further. Yet hourly wages have increased 2.6% in the last 12 months versus 2.0% in 2014. With the tightening labor market, wages are expected to continue to accelerate for at least a couple more years.

An interesting report from the San Francisco Fed earlier this year pointed out that the acceleration of hourly wages is happening despite the large number of Baby Boomers who are retiring from high paying jobs — while most new entrants to the labor market have below-average skills and therefore much lower wages.

As I wrote in my September 20 E-Letter, the Census Bureau report that median household income rose by 5.2% year-over-year, the largest increase in history. You may recall that I debunked that number due to revisions in the way it was calculated; still household incomes likely rose by at least 2.5-3.0% in the last year. So most families have more to spend, which is another reason why inflation is likely to continue to rise.

As I reported on Tuesday, consumer confidence is at the highest level since 2007 – another suggestion that consumer spending may remain firm just ahead.

No doubt, the Fed has all of the above-noted data in its models. Surely it is seeing rising inflation expectations, even though the Core PCE Index rose only 1.7% year-over-year. That is why I continue to expect the policy committee to raise the Fed Funds rate by 0.25% at the FOMC meeting on December 13-14.

In conclusion, this is likely to be the last year in a long while where we see inflation below the Fed’s target of 2%. Instead we’re likely to see both higher inflation and higher interest rates for the next couple of years – assuming we avoid a recession.

That, of course, is a big assumption especially if Hillary Clinton is our next president. Should she get her way – with higher taxes and more government regulation – that could push the already tepid economy into a recession by late next year.

This discussion could go on and on, but I’ll leave it there for today.

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