Last week, I argued that due to weaker economic data since January 1, the Fed should hold off on raising rates. However, over the last few weeks, several very credible commentators argued that higher inflation readings would put a rate hike into play. While inflation measures are increasing, rising wages are the primary reason for the increase. And as the US labor force is just beginning to see meaningful wage increase (which should support increased consumption expenditures), the Fed should still withhold rate increases for now.
Before looking at the data, let’s explain two key points. The first is, “why does the Fed focus on core inflation rates as much as total inflation?” Several sets of prices – most notably food and energy costs – are very volatile. For example, suppose the yearly wheat crop’s total yield drops by 15%. Prices would increase. But the next year, farmers would increase wheat plantings to take advantage of the higher prices. Supply would increase, lowering prices. These events would lead to an 18-24 month arc in food prices, which would increase overall inflation. The core rate, however, may not rise nearly as much, if at all, for a number of reasons.And if the core rate doesn’t rise, an analyst will think costs are contained – that the wheat price spike’s effect was limited to that one market.
Other markets – like copper – have longer cycles. Over the last 4-5 years, raw material extraction companies several very large projects that are currently flooding the world with raw materials. These projects continue producing to help pay for their massive cost. Like the shorter seasonality of the agricultural markets, longer price arcs exist for these materials. But, all these prices will eventually gravitate back towards a statistical norm. These wide price vacillations may or may not seep through to other prices.If they don’t, then we’ll see a wide divergence between core and total CPI, which is what the Fed is hoping for. But, if there is a higher degree of correlation, then the Fed gets nervous, and may be more inclined to raise rates.
