The Stock Market Doesn't Mind That the Fed Hasn't Fully Tamed Inflation

The Federal Reserve should approach inflation with caution. In September, the annual change in the U.S. Consumer Price Index (CPI) fell to 2.4%, but core inflation, which excludes food and energy prices, remained elevated at 3.3%. Essential goods and services such as healthcare, car and homeowners’ insurance, and even leisure activities like concert tickets, continued to rise in price. Lower oil prices helped pull down the headline inflation figure, but that drop could easily reverse, making the inflation outlook uncertain.

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Globally, China’s economic issues are pushing prices lower, as falling property values, consumer pessimism, and overinvestment are decreasing demand. However, this deflationary pressure appears to be weakening in the U.S., with non-energy goods only reducing the CPI by 0.2% in September. Meanwhile, non-energy services, which account for a significant 61.3% of the CPI, saw an increase of 4.7%. For example, shelter prices rose by 4.9%, and other non-energy services went up by 4.3%.

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There are four important points to consider when analyzing the current inflationary environment.

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First, inflation has a lasting impact on consumer behavior and psychology. Surveys conducted by the New York Federal Reserve Bank, Conference Board, and the University of Michigan show that one-year inflation expectations remain above 3%, closely aligning with core inflation and well above the Federal Reserve’s 2% target. These expectations influence both union wage negotiations and individual workers’ approach to pay discussions, as well as business strategies. A notable example of this is Boeing's recent labor negotiations, where the company offered a multiyear contract reflecting the rising wage pressures.

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Second, policymakers must acknowledge their past mistakes to avoid repeating them. The federal government spent a combined $4.5 trillion on COVID-19 relief under the Trump and Biden administrations, while the Federal Reserve purchased a similar amount of bonds and securities, greatly expanding the U.S. money supply. This stimulus significantly boosted consumer demand and led to headline inflation peaking at 9.1% in June 2022. While pandemic relief was necessary, it was likely too generous, causing workers to delay returning to the workforce, which prolonged the pressure on wages and prices.

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Rather than admitting that excessive government spending contributed to inflation, the Biden administration has further increased the federal deficit with initiatives like the CHIPS and Science Act and the Inflation Reduction Act. As a result, the federal budget deficit now stands at 7% of GDP, up from 4.6% just before the pandemic.

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With private companies ramping up investment in artificial intelligence and other technologies, competition for savings in financial markets between private investors and government debt will likely intensify. This could leave the Federal Reserve with two choices: allow interest rates to remain much higher than pre-pandemic levels or risk further inflation.

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U.S. Vice President Kamala Harris, the Democratic presidential candidate, has pointed to factors like corporate price gouging and landlords using algorithms to set rents as contributors to inflation. However, many economists disagree. For instance, the New York Federal Reserve found that supermarket chains have not increased their margins significantly, suggesting that rising grocery prices are more tied to wage increases and fluctuating commodity costs. Harris’ calls for regulating algorithmic pricing and targeting corporations may resonate with more progressive voters, but such measures could alienate moderates and swing voters. Algorithmic pricing is a common practice used by airlines and other industries to adjust prices based on demand, and banning it could lead to less efficient pricing, which could limit discounts and travel opportunities for lower-income individuals.

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Third, economic policy is often shaped by political agendas. A growing movement is seeking to discredit traditional economic thinking, such as "neo-liberal economics," and promote ideas like Modern Monetary Theory, which suggests that large deficits financed by printing money could fund generous social programs. The Brookings Institution has attempted to shift the blame for high inflation from excessive government spending to supply shortages, claiming that rising company margins, not COVID-19 relief, have been the primary cause.

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While corporate margins do increase when supplies are constrained, many producers of non-essential goods, like Ikea and Nike, are now facing pressure to lower prices as supply chain issues ease.

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To avoid a prolonged tradeoff between high interest rates and inflation, the federal government must either cut spending on entitlements, which account for over 60% of its budget, or raise taxes to levels more in line with European countries.

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Finally, moderate inflation combined with economic growth is generally positive for stock markets. The 25 years leading up to the Global Financial Crisis were characterized by elevated inflation, with the CPI averaging 3.1%. During that period, the S&P 500 delivered an impressive 13.7% annual return on average. Over the past two years, inflation has also averaged 3.1%, while stock prices have increased at an even faster pace, with a more than 20% annualized return. While stock gains are likely to slow in the future, what matters most for continued growth in share prices is steady economic growth and strong corporate profits.

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In conclusion, the Federal Reserve must continue to tread carefully as it navigates inflationary pressures. While headline inflation has fallen, core inflation remains stubbornly high. Government policies have contributed to inflationary pressures, and policymakers must be mindful of how their decisions affect both the economy and consumer behavior moving forward. At the same time, moderate inflation can provide a favorable backdrop for stocks, as long as economic growth continues to support corporate earnings.

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