Federal Reserve Chair Janet Yellen wants to rope more Americansinto the workforce before raising interest rates. That'smaking some of her colleagues nervous. They worry the labor marketcould overheat, forcing policy makers to raise rates much morequickly and trip the economy into a new recession.

Inflation will ultimately decide who is right, and, by severalmeasures, it's going up.

The Fed's preferred gauge of price pressures, PCE inflation, was1.7 percent in the 12 months through August after stripping outvolatile food and energy components. That's still below the Fed's 2percent target, but the highest it's been in two years. Theconsumer price index was 2.3 percent. Both show a decided, ifgentle, upward trend.

“The rise in core PCE inflation will serve to reinforce theargument of the centrists and hawks on the FOMC that the Fed isgetting closer to both its employment and inflation objectives,”Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. inNew York, wrote in a note to clients, referring to the rate-settingFederal Open Market Committee.

The trend is even clearer in two alternative measures that EllisTallman, director of research at the Cleveland Fed, likes to track:median CPI and his bank's “trimmed mean” CPI. Instead of takingout the segments that are consideredhistorically volatile, a trimmed mean removes whichevercomponents moved the most in that period, and so reveals somethingcloser to the central trend.

“We don't see inflation rearing its ugly head,” said Tallman.“On the other hand, we do see inflation in the medium term headingback toward 2 percent.”

Still, against the sharp drop in unemployment over the past sixyears, coupled with the Fed's inaction on rates, that's apuzzlingly slow rise.

One explanation: ”Wages have not grown really as stronglyas they should have, despite the fact they didn't moveinterest rates,” said Jeremie Banet, a fund manager at PacificInvestment Management Co. in Newport Beach, California.

Productivity the Culprit?

Banet and his colleagues have dug into CPI figures looking for apurer signal on what's happening with wages. They narrowed theirfocus not only to services, but also tossed out rents andtheir equivalents, as well as energy. The resulting “core servicesex-shelter” is up more than 3 percent in the year through August,significantly higher than average hourly earnings reported by theBureau of Labor Statistics.

To Banet, this evidence that prices are rising faster than wagesis a clue. Companies raise wages when productivity is high. Rightnow productivity is low. “That could explain why wages are notrising as much as you'd expect,” he said.

If true, and productivity remains weak, that would also supportYellen's decision to remain patient, as wages would be less likelyto contribute meaningfully to an upward spiral in inflation.

Fuel Injection on the Way

Less divination is required when it comes to the impact of fuelprices on headline CPI. Since mid-2014, oil prices have plunged,with one of several big dips coming in late 2015 into this year.The impact of that drop is about to roll out of theyear-on-year figures for the energy component of CPI.

In the 12 months through August, motor fuel prices droppednearly 18 percent. Should fuel prices remain exactly where theywere at the end of August, the year-on-year deflation willdisappear by November and turn into inflation that reaches 22percent for fuel prices by February. Given the 3.26 percentweighting for motor fuels in overall CPI, that would result in anupward swing of more than 1.3 percentage points in CPI fromAugust to February.

The caveat here is that Fed officials regularly ignore swings inheadline inflation caused by energy and food price changes. JanetYellen has long spoken of the “transitory” nature of oil's impacton inflation. But with a historical bias guarding against highinflation, can the Fed ignore energy on the way up, as easilyas they do on the way down?

“I think they can,” said Gennadiy Goldberg, aninterest-rate strategist at TD Securities LLC in New York. “But ifthere is a little more inflation on the core side at the same timethat headline is rising, that could catch their eye.”

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