Why the jobs report is more important than usual

The Fed's more than seven-year quest to generate inflation has started to bear some fruits, but likely too few to spur an imminent policy change.

Recent indications provide at least some hope that inflation is edging toward the U.S. central bank's 2 percent goal. That's the level Fed Chair Janet Yellen and the Federal Open Market Committee believe the economy should hit or least be on course toward.

Reaching that level is important for a Fed that is trying to normalize policy since going to a near-zero interest rate target and embarking on $3.7 trillion worth of money printing since late 2008. The FOMC won't move without knowing the inflation trajectory is solid.

"Clearly inflation (or lack thereof) gives Fed presidents the most pause when deciding to continue normalizing rates. While prices gained some traction in January, inflation expectations as measured by the New York Fed and University of Michigan remain low," Nick Colas, chief market strategist at Convergex, said in his daily note. "The Fed does not want to repeat Japan's deflationary experience in the 1990s."

Traders are betting against a Fed move anytime soon, assigning a 50 percent chance of a hike in November and 62 percent in December, according to the CME. There's virtually no chance assigned to March, with just a 2 percent probability. Market participants will be watching Friday's jobs numbers closely to determine whether wage inflation could push the central bank any closer to moving again after a quarter-point hike in December.

Inflation graph
Tommy Flynn | Getty Images

Of course, inflation is often in the eye of the beholder. Consumers weight it differently than policymakers like Yellen, who often is inclined to dismiss as "transitory" the type of factors that get the attention of shoppers.

The most widely publicized inflation measure is the consumer price index. The gauge the Fed most closely follows, though, is personal consumption expenditures. The difference essentially is that the CPI measures what consumers are buying while the PCE gauges what businesses are selling. CPI historically has run higher than PCE.

Over the past six months inflation as gauged by both measures has gone from being almost nonexistent to something a bit more. Core CPI, which strips out volatile food and energy prices, is now running at 2.1 percent, while the corresponding PCE gauge is at 1.7 percent — close to the Fed's long-run target, but not quite there yet.

So what has fueled the rise?

It certainly hasn't been gasoline prices, which continue to be on the decline despite a recent rally in oil. On average, a gallon of gas, at $1.88, is about a dollar cheaper now than it was a year ago. Gasoline prices aren't included in core CPI anyway, so they only move the headline number (including food as well) which is up just 1.3 percent.

Instead, the rise has come from health care and rent inflation, the latter of which is a major component of inflation gauges. That has some economists believing that there are some fundamental pressures on core inflation that likely would be influential on Fed thinking.

"Higher medical care and rent inflation look underpinned by fundamentals, and are probably here to stay," Goldman Sachs economist Zach Pandl said in a note to clients. "Trend-like core goods inflation is more surprising in light of the strong dollar, but without weakness in consumer-related import prices, this may persist, too. The component level details therefore show a convincing turn in core inflation, in our view."

One possible problem lies ahead: While components like health care and rents are important — the latter in particular a significant demand indicator — sustainability will be impossible without rising wages.

There has been some evidence lately that workers can look forward to fatter paychecks, with January's annualized rate at 2.5 percent. However, recent indicators show some possible problems.

The Institute for Supply Management index readings this week both for manufacturing and services were below 50, indicating contraction. On one hand, a tightening labor market would indicate less slack and thus likely put pressure on wages. However, a jobs picture in retreat due to recession fears would hamper wage growth.

Market expectations for inflation are lower than the Fed's. In fact, a recent St. Louis Fed paper indicated that if inflation progresses on the path indicated in the break-even securities trade, oil theoretically would have to trade at zero dollars a barrel by mid-2019.

Friday's nonfarm payrolls report, always a closely watched data point, will be especially important then as an indicator for the future path of inflation. Wall Street expectations are for a 0.2 percent monthly rise in average hourly earnings, on top of 195,000 new jobs and a steady unemployment rate at 4.9 percent.

"An unexpected stall in employment ... is likely to trump even a modest rise in prices," Lindsey Piegza, chief economist at Stifel Fixed Income. Friday's "employment report is rapidly becoming even more important than usual as many analysts are looking to Friday's number to determine whether or not the recent 'improved' sentiment in the marketplace can and will be sustained."