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”
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.