Are inflation and inflation expectations heading for a period of high inflation?

Is the American economy poised for a period of high inflation? The median forecast from economists surveyed by Bloomberg News called for a three-year high in inflation in the second quarter.

Whether that’s enough to cause the Federal Reserve to hold off on raising interest rates this year is still the central question for investors and analysts. The odds of a rate increase in September or later this year have risen to around 50 percent in recent days.

Here’s why investors need to be on the lookout: There are several statistics—including core PCE, the Fed’s preferred measure of inflation—that point to high inflation ahead.

I’ve already said the energy price hike is temporary, but there are two other factors that would warrant higher interest rates: Wages and inflation expectations. Below is a more in-depth look at those variables.

Wages

We’ve all heard about businesses and their need to raise wages to attract and retain employees. But has that wage increase been visible in the current numbers?

In a year, companies have already raised the average hourly wage for non-supervisory workers by $1.60, the most in 13 years. As the unemployment rate increases, wages will likely continue to rise. Plus, the trend is expected to continue throughout the rest of 2017.

But will employers keep raising wages further this year, or will there be a pullback? Another notable wage figure comes from the productivity index, which is calculated by subtracting the cost of capital from the output of capital. Unfortunately, productivity improved only 0.4 percent in the second quarter, down from 0.7 percent the previous quarter.

Investors need to know when to expect the recent gains in wages to moderate and support a rate hike this year.

Inflation Expectations

Fed Chair Janet Yellen has said that the central bank will raise rates gradually this year. While that remains the case, she has also warned that “some inflation above 2 percent is still likely.” Investors are keeping close watch on inflation expectations to assess the probability of a rate hike. When inflation expectations rise, they argue, the probability of a rate hike rises, too.

Let’s take a look at two different indexes—the January 2019 CPI, a longer-term measure used by the Fed, and the May 2019 Consumer Price Index—for a better sense of where inflation expectations are headed. Over the last two decades, the indexes have stayed relatively stable.

On an annual basis, inflation expectations are forecast to average 2.7 percent over the next two years. Over the course of the year, we’ll also see how well wage inflation will contribute to that. As of May 2018, nominal wages increased 2.9 percent compared to the same time period last year. If the two offset each other, the rate of inflation will rise about 0.6 percent. That’s a slight increase, but a relatively low number for consumer prices.

Both of these inflation measures have also improved from last year, but the estimates are still below the Fed’s target of 2 percent annual inflation over the longer term. And it’s far from clear when these increases will peak.

If inflation expectations rise further, there will probably be another reason to keep interest rates low: stronger-than-expected wages could weigh on inflation. Investors should still watch these indicators as we move closer to the end of the year.

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