This Factor Should Push The Fed Toward Liftoff

Summary

• Recently corrected energy prices have helped to quell what might otherwise have been a hotter inflation environment.
• Despite factors still in play that work against price rise near-term, their transitory nature will eventually become obvious.
• While some data still indicate inflation is a non-issue, the monthly Producer & Consumer Price Indexes show signs of a heating inflation situation.
• Economic growth (ex-energy), a tightening labor environment, and normalizing currency and energy markets should push the Federal Reserve toward liftoff.

In the long-biased and hopeful stock market, and the media that follows it, it seems to me that a great deal of the discussion around the Federal Reserve has to do with reasoning against a near-term interest rate hike. There is doubt about the Fed's plan for liftoff, and I guess skepticism is sensible given how long it has been since the Fed last tightened monetary policy. However, reasons also exist today that are pushing the Fed toward a near-term interest rate hike. This is one of them, heating inflation.

The Fed has two mandates. It targets full employment for the U.S. economy and it targets a healthy level of inflation, or a 2% rate. With regard to employment, the Fed justifies its dovishness to date by pointing to slack in the labor market. In this regard, the Fed points to part-timers with a preference to work full-time and those individuals who have fallen out of the labor market driving deterioration in the labor participation rate.

With regard to inflation, Fed Chair Yellen indicated in her testimony to Congress this week that recent downside pressures on consumer prices resulting from declines in energy prices are transitory. If not anchored, then energy price decline is less meaningful for the Fed in its long-term planning. Still, she notes expectations are for stable though still relatively subdued energy prices into the foreseeable future. Indeed, recent developments around the Iran nuclear issue and the removal of sanctions on the significant oil producer seem to portend the same. Thus, one would expect the force against price rise to remain in place. Even so, there are signs of heating inflation in the economy.

Core inflation excludes volatile food and energy prices and is given far greater consideration in the Fed's long-term planning. Core inflation "has remained relatively low," using the Fed's own description from its July 15 presentation. The Fed indicates that lower energy prices and other commodity price decline along with little pressure from wages have served to quell inflation since the middle of last year. Core PCE, found in the Personal Income & Outlays Report published monthly by the Bureau of Economic Analysis, only rose 1.2% year-over-year in May (the latest available data), which was down slightly from its year earlier pace. And yet there are signs that prices are warming.

This week produced two key measures of prices, the Producer Price Index (PPI) and the Consumer Price Index (CPI). Earlier this week, the PPI Report showed Core PPI (less food and energy) rose 0.3%, against expectations for an increase of 0.1%. Anything above a monthly gain of 0.2% gets my attention. We should note that the significant gain in core producer prices followed a 0.1% decline in May. The year-to-year change in Core PPI was +0.8%, though, versus a 0.6% increase in May. Now, this information in isolation is frankly not all that concerning. The problem is that it is not in isolation. It combines with a telling and concerning uptick in prices at the consumer level, where the Fed is watching closely.

The Consumer Price Index was reported Friday morning before the market open. It shows prices rose 0.3% in June against expectations for the same, but slightly lower than the 0.4% increase in May. Excluding food and energy, which is data that matters more to the Fed, Core CPI increased 0.2%, marking an uptick against a gain of 0.1% in May. Importantly, prices rose 1.8% year-to-year at the core level, marking an uptick from 1.7% in May. I've been following the price data for months now, and it has been trending higher. Note the chart below, but pay attention to the bars, not the line, for the changes in Core CPI. Save for last month, the latest trend has been for steadily rising prices.

Year-to-Year Price Change from Bloomberg & Econoday

The impact of the oil price drop has probably helped to quell what could otherwise have been an inflation environment now calling for Fed action. Instead, the Fed has had the luxury of time to wait out the strengthening dollar situation a bit, which it certainly wanted to do while the Greek crisis was at its height of concern. A Grexit might have severely disrupted the value of the euro due to questions about the fate of the eurozone, and that threatened to take the dollar quickly to dangerous heights for U.S. exporters.

Indeed, the strengthening dollar, the result of divergent central bank policies between the U.S. and Europe & Japan, is at the heart of the energy price falloff along with the supply glut that developed on North American energy production efforts. As the European economy improves and the European Central Bank (ECB) approaches its target end date for its extraordinary easing measures in 2016, the value of the dollar should normalize to a lower level. That in turn, combined with the impact of recent cuts in energy capital spending, should drive oil prices to a higher level. The end result of the evolution of the transitory issue the Fed mentioned is renewed fuel for inflation and the end of zero rates in the U.S.

The government's nascent deal with Iran may allow the Fed some more of the same leeway it has benefited from. But heating inflation is an issue that is not likely to go away given economic growth in the U.S. (ex-energy), the tightening labor situation and an eventual correction in the currency markets. I follow the markets closely and publish regularly, and invite interested parties to follow my column here at Seeking Alpha.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.