Inflation Redux

Renewed uncertainty about the future path of inflation is driving both stock and bond markets. After peaking at about 9% in March 2022, inflation as measured by the trailing 12 months, change in the Consumer Price Index (CPI), had been falling steadily to 2.4% in September 2023. However, since then it has been climbing, reaching the latest annual rate of 3.4%, well above Fed targets.

Inflation is usually either “cost push,” or “demand pull.” Cost push is a rise in general price levels from increasing costs without a corresponding increase in value. Demand pull is too much money chasing too few goods. Both causes can explain recent bouts of inflation.

Increasing costs due to the temporary supply chain disruptions from the pandemic, and boycotts of Russian oil after its invasion of Ukraine, help to explain the rapid run-up of inflation to 9%. Classic “cost push.” As these costs work through the economy, this inflation can become transitory.

Additionally, to help soften the economic impact of the pandemic-induced “lockdowns,” the government ran massive deficits to 120% of GDP. Deficits have remained at this level even as the economy bounced back. Government spending in response to the pandemic-induced slack economy may not have been inflationary, but in today’s more robust economy can result in price increases.

Where to go from here? No doubt the Fed is committed to not let inflation get out of hand. Consequently, any cut in interest rates will depend on the path of inflation. While we have enjoyed a “soft landing” so far, as the Fed keeps its Federal Funds rate high, it is reasonable to expect market-determined, longer-term interest rates to remain high, increasing the probability of a recession. Yet, the spread between longer- term nominal interest rates and inflation-adjusted rates is still a reasonable 2.3%, signaling modest inflation expectations. In any event, economic uncertainty has increased and we can expect continued market volatility.

Market Review  

Stocks

In April, stocks were down from 1.3% (emerging markets) to nearly 7% (domestic small cap markets). Much of this drop was triggered by inflation measures greater than expected, putting in doubt the Fed’s commitment to cut interest rates. Additionally, a pause for a breather after the robust markets (S&P 500 up 23% over the past year) is not surprising – investors shedding risk.

Year-to-date, the S&P 500 was up 6.0% outpacing other market indices, thanks to ongoing enthusiasm for the largest tech stocks: Amazon, Google, Meta and Nvidia, primarily. Year-to-date losses in Apple and Tesla have curtailed talk of lumping tech stocks into the so-called “Magnificent Seven.” Except for stocks of small companies (off 2.2%), other markets were up over this period.

Bonds

Yields increased this month due to dashed expectations for a rate cut in the immediate future.  Consequently, bonds were off 0.2% at the shorter end (1-3 years) and 4.4% for longer maturities (5-10 years) both this month and year-to-date.

Over the past two years, real interest rates (adjusted for inflation) have risen from zero to 2.3% for five-year Treasuries. While a jump of this magnitude in a short period creates uncertainty, zero to negative real interest rates were never sustainable.