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U.S. inflation picks up as era of low prices comes to a close

In this April 26, 2017, photo, gas is pumped at a filling station in Nashville, Tenn.

The Associated Press

A closely watched measure of inflation in the United States jumped more than expected in January in a fresh indication that price pressures are building in the world's largest economy.

An index of what consumers pay for everything except food and energy rose 0.3 per cent last month, outstripping predictions by economists. On average over the past three months, the core consumer price index has grown at an annualized rate of 2.9 per cent, the fastest pace in seven years.

Investors are keeping a close watch on changing prices as an era of ultralow interest rates draws to an end. Last week, stocks tumbled around the world while investors digested the possible ramifications of higher-than-expected wage growth in the United States. The fear among investors is that the U.S. Federal Reserve and other central banks could move in a more aggressive fashion to ward off possible overheating in their economies. Investors believe the Fed will raise interest rates three times this year, starting in March.

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"Higher inflation is already here and the Fed will be forced to respond soon," Michael Pearce, a senior U.S. economist at Capital Economics, wrote in a note to clients on Wednesday. Mr. Pearce said he now expects the Fed to raise its benchmark interest rate four times this year rather than three.

Unlike last week, investors remained sanguine about the new inflation reading. On Wednesday, U.S. stocks rose for the fourth day in a row. But more volatility is likely ahead, economists said, as investors adjust to a changing reality.

"Inflation is set to accelerate meaningfully" in the next couple of years as unemployment continues to decline and wage pressures grow, said Mark Zandi, chief economist at Moody's Analytics. He expects core inflation in the United States will rise above 2 per cent later this year and will be closer to 3 per cent by the middle of next year. "This long, steady decline in inflation that began 35 years ago is over."

The Bank of Canada is also keeping an eye on inflation south of the border. The central bank has adopted a cautious tone as continuing negotiations raise the possibility that the North American free-trade agreement will end. But it may now have to acknowledge that inflationary pressures are building.

"A similar situation could play out here in Canada," said Paul Ferley, assistant chief economist at Royal Bank of Canada. If it does, the Bank of Canada might respond with higher interest rates through 2018, he added.

His colleague, Nathan Janzen, pointed out in a note that Canada's labour market is tight, setting conditions for rising wages. "Canadian labour markets are probably close to, if not somewhat beyond, long-run capacity limits. That is good news for wage earners, at least in the near term, although it also suggests interest rates are more likely to continue grinding higher," Mr. Janzen said.

That process may not be as gradual as anticipated. "We're going to see the central banks move a little faster in 2018 than maybe some people had thought," David Dodge, the former governor of the Bank of Canada, said in an interview with The Globe and Mail on Wednesday. "It's much more urgent for the Americans to move, because we've had this enormous shift in U.S. fiscal policy."

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In recent months, the Trump administration has enacted a major tax cut and reached a deal to boost military and domestic spending. Economists would usually recommend such fiscal stimulus to strengthen a weak economy. But the U.S. economy is expanding and unemployment is low.

"It's very wrong-headed economic policy," Mr. Zandi said of Moody's Analytics. "It's as if you opened up an economics textbook, read it and decided to do just the opposite."

Megan Greene, chief economist at Manulife Asset Management, cautioned against reading too much into Wednesday's figures from the consumer price index. Inflation will appear to pick up further in the second quarter of this year, she said, but that is partly the result of comparisons with last spring's figures, which were depressed for one-off reasons such as a price war among cellphone providers. After that, she expects inflation to creep up rather than surge forward.

The Fed and its new chair, Jerome Powell, will face a tricky path. The central bank has long sought a return to what it believes is a healthy level of inflation, or about 2 per cent a year (the Fed focuses on a different inflation measure than the consumer price index, and it has remained stubbornly below the central bank's desired threshold).

But if price pressures build more quickly than anticipated, the Fed could be forced to act more assertively to rein in the economy. That would put the central bank on a collision course with the new administration. "If the Fed adopts a much more hawkish stance, it risks pouring cold water all over the tax plan and the budgetary spending," Ms. Greene of Manulife said. "I don't think the administration will sit by and watch that happen."

With a report from Dawn Calleja in Toronto

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