The Rate Debate: Inflation Says Go, Markets Say Stop

Inflation has firmed to the point that the Federal Reserve can be more comfortable about raising rates again, but investors aren’t there yet

By Justin Lahart


The prices are starting to look right for the Federal Reserve to raise interest rates again. Markets aren’t.

The Labor Department on Tuesday reported that consumer prices rose 0.4% in April from March, marking their sharpest monthly gain in over three years. The increase was driven by a rebound in gasoline prices—regular gasoline averaged $2.11 a gallon last month versus $1.97 a month earlier.

But excluding energy, prices rose 0.2% on the month, after a flat reading in March. That is an indication that the impacts of not just lower energy prices, but of the dollar’s strength, are beginning to fade.

With those drags on inflation easing, the tightening labor market should have a more pronounced effect on prices. Indeed, prices for services excluding energy, which are less exposed to the dollar (you can’t import haircuts), have been far stronger than goods prices, which are.

That isn’t to say that inflation is about to roar ahead. Even with the unemployment rate at 5%, wage growth has only picked up slightly, with average hourly earnings in April up just 2.5% from a year ago.

They will have to grow more quickly than that for the Fed to reach its 2% inflation target. Moreover, even if employers have to pay workers more, it isn’t clear how easily they would be able to pass those costs on to consumers.

Rather, labor’s share of U.S. income, which has dropped sharply since 2000, might start to go up—a nice outcome for workers, though not for profit margins.

Still, with prices looking firmer, the Fed’s expectation, as of March, that it would raise rates twice this year has hardly been derailed. That would especially be the case if monthly job gains bounce back after April’s slightly disappointing payrolls figure.

A June rate increase would be a stretch. Still, a strong May jobs report along with upward revisions to previous months could make it happen.

Adding to the case for an earlier move were April retail sales figures last week and industrial production figures on Tuesday that indicate the economy is reversing its winter weakness.

If not June, then July certainly seems like it could be a go. Yet futures are now pricing in only about a 25% chance that the Fed raises rates by July, and only place about an 80% chance of the Fed moving at all this year.

Investors may be just a few economic reports from a major reassessment of what is going to happen to rates.

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