In­fla­tion’s heat­ing up, and that’s a good thing

▶ Con­sumer prices in Jan­uary had their big­gest rise since 2012 ▶ The FOMC “will be less wor­ried about in­fla­tion be­ing too low”

Bloomberg Businessweek (North America) - - Contents - Car­los Tor­res and Vic­to­ria Stil­well

Fed­eral Re­serve Chair Janet Yellen and her col­leagues are get­ting ex­actly what they wished for—just way ear­lier than they, and most econ­o­mists, ex­pected.

The prices of goods and ser­vices that con­sumers buy, ex­clud­ing food and fuel, rose 0.3 per­cent in Jan­uary from De­cem­ber, the big­gest gain since 2012, ac­cord­ing to the Depart­ment of Com­merce’s in­fla­tion mea­sure that the Fed prefers to rely on. The Jan­uary jump lifted the an­nual in­crease in prices, ex­clud­ing food and fuel, to 1.7 per­cent. That’s higher than the 1.6 per­cent the Fed pro­jected for core in­fla­tion in the fourth quar­ter of 2016.

That may seem like a small change, but the cen­tral bank’s goal is to get to­tal in­fla­tion, in­clud­ing food and fuel, up to 2 per­cent, a level con­sis­tent with a healthy econ­omy. Any­thing less ex­poses the econ­omy to the risks of dis­in­fla­tion and de­fla­tion, which have ham­strung Ja­pan for decades. In a dis­in­fla­tion­ary or de­fla­tion­ary en­vi­ron­ment, con­sumers have no com­pelling rea­son to spend more, since prices go down or in­crease at a snail’s pace. Un­der mod­er­ate in­fla­tion, they want to spend rather than have their buy­ing power re­duced.

The jump in prices makes it more likely that mem­bers of the pol­i­cy­mak­ing Fed­eral Open Mar­ket Com­mit­tee, which next meets on March 15-16, will con­tinue to raise in­ter­est rates. The trick will be to time those in­creases in a way that keeps growth hum­ming while pre­vent­ing prices from over­shoot­ing their goal. Roberto Perli, a for­mer Fed of­fi­cial who’s now a part­ner at Cor­ner­stone Macro, an eco­nomic re­search firm in Wash­ing­ton, says he doesn’t think the Fed will raise rates un­til June. But, he says, “Over­all, the com­mit­tee is go­ing to see this as good news and will be less wor­ried about in­fla­tion be­ing too low.”

Be­fore the Jan­uary in­fla­tion data, in­vestors had as­signed very low odds to the prospect of any rate in­crease this year as tur­moil in global mar­kets and the pokey U.S. re­cov­ery of­fered proof that su­per­low rates were still needed. Ex­pec­ta­tions of a hike rose af­ter the in­fla­tion news, with traders’ odds ris­ing above 50 per­cent for at least one rate rise by the Fed’s De­cem­ber 2016 meet­ing, ac­cord­ing to Bloomberg cal­cu­la­tions. Chances of a hike by the Fed’s June meet­ing climbed to 35 per­cent on Feb. 26, the day the in­fla­tion data were re­leased, from 24 per­cent the day be­fore.

When look­ing at long-term price trends, Fed of­fi­cials fo­cus on the

Com­merce Depart­ment’s in­fla­tion mea­sure that in­cludes prices for food and fuel. That over­all mea­sure has been dragged down by a 5.2 per­cent yearly de­cline in what the agency calls en­ergy goods and ser­vices. But even with cheap gaso­line and other fu­els weigh­ing down the in­fla­tion gauge, prices over the 12 months through Jan­uary climbed 1.3 per­cent, com­pared with a 0.7 per­cent in­crease for the 12 months through De­cem­ber. As oil prices sta­bi­lize, the gauge is likely to keep mov­ing to­ward 2 per­cent.

Fed of­fi­cials have been more op­ti­mistic than the mar­kets about their abil­ity to strengthen growth and in­crease prices. When they raised the fed­eral funds rate by a quar­ter of a per­cent­age point in De­cem­ber, they pen­ciled in a full per­cent­age point of ad­di­tional tight­en­ing in 2016. Fed gov­er­nors and Fed bank pres­i­dents pre­dicted that in­fla­tion would reach 2 per­cent by the end of 2017. And they sug­gested that fu­ture rate in­creases would de­pend on “ac­tual” gains in in­fla­tion— solid proof that a price up­turn was un­der way.

With the 2 per­cent goal within reach, any de­ci­sion to hold off from rais­ing rates may be­come tougher to ex­plain to in­vestors, since the Fed doesn’t want to dam­age its cre­den­tials as an in­fla­tion fighter. Though wel­come, the jump in prices “is go­ing to make the Fed’s job a lot more dif­fi­cult,” says Ryan Sweet, a se­nior econ­o­mist at Moody’s An­a­lyt­ics in West Ch­ester, Pa. “They should be more con­fi­dent that in­fla­tion is go­ing to hit their tar­get fairly soon—late this year or early next. That re­ally makes their com­mu­ni­ca­tion and their de­ci­sion in March much more chal­leng­ing.”

The bot­tom line The Fed didn’t ex­pect in­fla­tion to be this high un­til the end of 2016. In­vestors must re­cal­cu­late the odds of rate hikes this year.

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