KEY DATA: CPI: 0%; Year-over-Year: +1.4%; Excluding Energy: +0.3%; Year-over-Year: +2%/ Real Hourly Earnings: +0.4%; Real Weekly Earnings: 0.7%

IN A NUTSHELL: “Inflation may not be high, but it is clearly rising, and that is something the Fed will be watching closely.”

WHAT IT MEANS: Energy has dominated the discussion as the large declines brought smiles to consumers’ faces but frowns to investors. But energy comprises less than 7% of the consumer costs. What happens to the prices of the rest of the goods we buy is more important, unless you think oil prices can keep falling 40%. Eventually, we approach zero, as in zero U.S. fracking companies. I don’t think we get there, so I will focus on the non-energy consumer costs. Here, we are seeing price increases starting to accelerate. The January headline Consumer Price Index number, which was flat, totally misrepresents the report – as usual. For the first time in a very long time, every component except energy was either flat or up. Food costs were the one flat number, largely because the egg price surge is being unwound. Otherwise, food costs are also starting to increase, especially cakes, cupcakes and cookies. And if you eat out, well you are paying more as well. Prices of medical care, clothing, vehicles, transportation and shelter were all up solidly. Services, which are nearly two-thirds of consumer spending, continue to rise at a strong pace. Even commodities, when you exclude energy, are up. In other words, inflation pressures are starting to build across the economy.

Low inflation has saved workers, whose incomes have risen modestly. But similar to prices, wage gains are picking up. Average hourly earnings and weekly earnings rose solidly in January, even when adjusted for inflation. The tight labor market, which the declining unemployment claims show is tightening further, is finally translating into better wage gains. That bodes well for future consumer spending but should put additional pressures on prices.

MARKETS AND FED POLICY IMPLICATIONS: While investors watch oil and react in a lock-step manner, following energy costs up and down, inflation continues to move back toward normal. At the end of last year, I warned that inflation could break the Fed’s target rate by spring. That forecast assumed energy prices would be largely stable, which it turns out was a pretty poor assumption. That said, headline inflation is accelerating and excluding energy (my preferred measure) or excluding food and energy, price gains are at or above the Fed’s target. Yesterday, we saw that producer prices are beginning to rise and while the pathway from wholesale to retail is hardly direct, the messages being sent is that the inflation is not something that will keep the Fed from tightening. However, the Fed needs to delink itself from the quarter-to-quarter insanity in the equity markets. A strong dollar that lowers earnings is irrelevant unless there is a major impact on exports. What about oil? There is nothing the Fed can or should do about the price of oil. It is being driven by supply and we all know, supply-side economics should be left to run its own course. As for the manufacturing recession, the sharp January production increase hints it may be modest or even over. Meanwhile, wage pressures are building, inflation is slowly accelerating and growth should be quite solid this quarter. Maybe the nattering know-nothings of negativity who fret about falling stock prices and claim that the Fed’s quarter point increase killed growth think the world revolves around stocks, but the Fed shouldn’t. The economy is evolving as the Fed members thought it would when they raised rates in December and there is little reason to believe that rate hikes will stop with that one move.