Inflation looks real this time

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Inflation may have arrived — the worrisome kind, not the manufactured kind.

Since the Federal Reserve started “printing money” in 2008, inflation hawks have warned of runaway price increases that could overrun the economy. Those have largely been false alarms; annual inflation during the past six years has averaged just 1.6%, with a 2.1% rise in prices during the past 12 months. Many economists have even cautioned that deflation is a bigger risk than inflation.

But new government data provide a genuine reason to worry. Labor costs rose by 0.7% in the second quarter, the biggest jump since right before the recession started in 2008. Economists had been expecting a more modest gain of 0.5%. Pay is hardly exploding, but if the value of pay and benefits continues to grow at a faster pace, it could cause the kind of inflation that tends to be lasting — and trigger the biggest change in Fed policy since the recession began.

Financial markets tanked following the news of higher labor costs — with the Dow and S&P 500 both down more than 1.5% — though traders attributed much of the loss to geopolitical tensions and other economic indicators that were weaker than expected. Still, investors have long worried that markets are too complacent about the risk of inflation and rising interest rates. That's one reason many investors have been predicting a 10% or even 20% correction

The textbooks teach that inflation occurs when too much money flows through the economy. That’s why inflation worrywarts have been miserable for the past six years. The Fed’s controversial “quantitative easing” policy seems to be a formula for inflation, because the Fed basically creates money through the purchase of huge amounts of bonds. But the new money that has flowed to banks has largely remained on deposit at the Fed, instead of circulating throughout the economy. In fact, most inflation during this time has come from hikes in the cost of energy and food, for reasons having nothing to do with Fed policy.

The inflation equation

What's been missing from the inflation equation is wage growth. Labor costs are still the biggest contributor to the overall cost of many goods and services, and they have, not surprisingly, been stagnant as employers benefit from a large pool of surplus labor. Average pay has risen by less than 2% per year since 2008, while many companies have been cutting, rather than expanding, benefits. With pay subdued, Fed policymakers have reasoned, it’s highly unlikely inflation will skyrocket — and they’ve been right.

If the latest pay gains stick, however, companies will try to pass on their own higher costs to consumers in the form of higher prices. That’s the kind of inflation the Fed worries about. Modest inflation — say, between 2% and 3% — wouldn’t necessarily be a bad thing, especially if pay gains for workers exceeded price increases. That’s how people get ahead. But the arrival of legitimate inflation could also force the Fed to rein in its super-easy monetary policy sooner than expected, which could rattle financial markets and undermine a growing sense of optimism about the economy.

The Fed is already close to winding down its quantitative easing program, with the final bond purchases likely to come in October. The Fed has telegraphed that move, and the markets have adjusted. The wild card now is the timing of the Fed’s first interest-rate hike, which many investors expect sometime in the middle of 2015. The Fed’s short-term rates have been close to 0 since 2008, which has only been possible because inflation has been so low. Since raising rates is the traditional way to head off inflation, the Fed could move sooner than markets anticipate, if it feels the risk of inflation is intensifying.

Job growth has been strengthening, with the unemployment rate dropping from 6.7% to 6.1% so far this year. So it makes sense that wages would rise as labor-market slack tightens. “If the unemployment rate keeps declining, compensation pressures simply have to increase,” writes economist Joel Naroff. “Most members of the Fed appear to believe it will be a lot later and not very rapidly, but I am not that sure.”

The recent selloff in stocks and bonds — along with rising rates on Treasuries — represents the standard reaction when investors feel inflation might become a problem or the Fed might tighten. It’s also possible the recent compensation spike was an anomaly, with labor costs set to settle back into a worry-free range. Inflation has certainly pulled a disappearing act before.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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