One of the reasons the Fed has been raising interest rates is to keep inflation in check. Earlier this week the Consumer Price Index showed that prices at the consumer level increased by 0.2% in May. The report also showed prices were up 2.8% over May 2017 and that is the highest year over year rate since February 2012. This could put more pressure on the Fed to make more rate hikes than previously thought.
The Fed prefers to use a different gauge of inflation, one that is issued by the Commerce Department. The target inflation rate for the Fed is 2% and that is where the Commerce Department’s indicator came in for March and April. This indicator tends to run lower than CPI.
Several Fed officials have stated that if inflation goes slightly over their target rate it shouldn’t be a big deal. My bigger concern is that the Fed and others are possibly underestimating how high inflation may go and how soon it may get there. A report from earlier this week caused my concern to grow.
The NFIB Small Business Optimism Index for May was released on June 12. The index came in at 107.8 and that is the second highest reading in the 45-year history of the index. The only higher reading was in 1983 and that was a reading of 108. Unlike many other confidence and sentiment indicators, the NFIB survey doesn’t seem to have a contrarian effect.
The items of concern for me were in the various components of the index. First, there were two different areas that hit record highs—compensation increases and expansion plans. In all, 35% of business owners have increased compensation to employees and 34% plan to expand. Those are both the highest readings ever for those two categories. A third part of the survey showed a ten-year high and that was the 19% that are planning price increases.
What all of the parts of the NFIB survey show is that the economy is really strong right now. However, they all also have the potential to push inflation higher. Wage increases are great for the workers, but they are being paid for with price increases. Expansion plans are great for the company, but they too can create additional inflation pressures due to increasing demand for products, etc.
This is why I am concerned that the Fed may be aiming too low on the rate hikes. There appear to be more signs that consumer and producer prices will increase at a greater rate going forward than they have in the past year. While the Fed wants to keep consumers and investors calm, they also have to be realistic with their outlook.
All signs point to the economy continuing to improve and obviously that is good news. The one thing we don’t want is rampant inflation tripping up the expanding economy. A little bit of inflation is actually good for the economy, but rampant inflation can lead to recessions.