Watching wages for signs of inflation - Wells Fargo

"The PCE deflator has only briefly brushed the Fed’s 2 percent target since the start of the expansion," notes the Wells Fargo Research Team.

Key quotes:

"Nevertheless, most FOMC members remain confident that inflation will move higher from here. In the Committee’s most recent economic projections published in June, the median estimate for where inflation would end the year was 1.6 percent and 1.7 percent for headline and core inflation, respectively, while both measures were projected to end 2018 at 2.0 percent. Although those estimates will likely come down a tick or two following recent months’ softness, the path remains upward and is a key factor in the Committee’s baseline outlook to further raise interest rates over the next year."

"The FOMC’s confidence that inflation will head higher over the next year and a half hinges critically on the assumption that as resource slack is absorbed, upward pressure on prices follows. While resources include both labor and capital, the link between slack in the labor market and inflation garners more widespread attention. As unemployment declines, firms need to pay higher wages to attract and retain workers, and those costs in turn generate the need to raise prices. Over the past couple of years, the unemployment rate has fallen to where it is now below many estimates of full employment, while inflation—headline or core—has remained stubbornly below 2 percent. The result has been to closely watch wage growth as a sign of future inflation."

"Wage growth has remained frustratingly low for workers and policymakers alike. After increasing only about 2 percent a year in the early years of the expansion, average hourly earnings began to strengthen in 2015. The uptrend has fizzled by multiple wage measures this year, however, and wage growth remains weak by historic standards. There are some signs that higher pay may be in the offing. Job openings are at an all-time high, underemployment is shrinking, and the share of small businesses raising compensation is hovering near cycle highs. But even if we see stronger wage growth, will it lead to more inflation?"