ANALYSIS-U.S. inflation stirring as medical costs, rents climb

WASHINGTON, May 29 (Reuters) - A turn higher in U.S. inflation could lead officials at the Federal Reserve to raise interest rates sooner and a bit more aggressively than financial markets expect.

The central bank has repeatedly described inflation as too low, but the pickup in prices reflects a shift in some areas that look likely to apply upward pressure for some time to come.

"The increase has potential to be more than just a flash in the pan," said Jacob Oubina, senior U.S. economist at RBC Capital Markets in New York.

Two areas in particular look set to drive inflation toward the Fed's 2 percent goal: medical care costs and rents. Their upward track is unlikely to change anytime soon, economists say.

And another more fundamental force - wages - may also soon get into the act.

Cuts in federal Medicaid payments to hospitals and doctors helped subdue inflation last year. But that anchor is now gone, and medical care inflation hit a seven-month high in April.

At the same time, a move away from homeownership has pushed up rents, which are at the heart of the shelter costs that comprise nearly a third of the Consumer Price Index. Shelter recorded its largest 12-month rise in six years last month.

Those factors helped lift the CPI to a 2 percent gain, while the core index, which strips out food and energy costs, hit an eight-month high of 1.8 percent.

The Fed targets a different inflation measure, the so-called PCE price index, which tends to run cooler. But that gauge is also expected to move higher when the April data is released on Friday, with the core index hitting its highest point in more than a year at 1.4 percent.

That would put it at the bottom of the 1.4 percent to 1.6 percent range that most Fed officials forecast for the fourth quarter of 2014 just a couple months ago. A closely watched forecast from the Cleveland Federal Reserve Bank suggests it will have reached 1.5 percent by May.

"We think a number of policymakers at the Fed and many market participants are overly complacent," said John Ryding, chief economist at RDQ Economics in New York.


Financial markets expect the Fed, which has kept benchmark interest rates near zero since December 2008, to wait until at least the middle of next year to tighten policy. But an unexpectedly swifter rise in inflation could shift bets sharply.

The New York Fed's latest survey of banks it deals with directly found economists expect a rate hike when the core PCE price index reaches 1.8 percent. If current forecasts are correct, that could happen sooner than markets expect.

One potential warning sign is the Atlanta Fed's "sticky" CPI index, which tracks a basket of goods whose prices tend to follow a steady course. That index posted its largest rise in 12 months in April.

"Inflation is closer to the Fed's target than policymakers think," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ in New York.

In the U.S. bond market, however, the yield on the benchmark 10-year note has recently plumbed 11-month lows below 2.5 percent, a sign investors think the Fed will be able to move rates up slowly.

"Investors may be extrapolating ultra-loose monetary policy a little too far into the future," said Peter Molloy, president at Edison Investment Research in New York.

Indeed, many economists say falling rental vacancy and homeownership rates are likely to keep upward pressure on rents, while the introduction this year of President Barack Obama's signature healthcare law, which expanded Medicaid coverage, has led to an increased demand for services that has outpaced supply.

So far, wages have been the missing inflation ingredient.

Over the past 12 months, average hourly earnings have risen just 1.9 percent, barely off their post-recession low.

But surveys ranging from the National Federation of Independent Business to the Philadelphia Fed show firms are increasingly raising wages to retain and attract employees.

"That's a good thing, but we haven't seen it on a broad basis across the country," said Sam Bullard, a senior economist at Wells Fargo Securities in Charlotte, North Carolina.

(Reporting by Lucia Mutikani; Editing by Paul Simao)