Analysis: Assessing inflation’s impact

Positive inflation trends continue with the latest report from the U.S. Bureau of Labor Statistics showing that the Consumer Price Index (CPI), a benchmark inflation measure, rose 2.9% for the 12-months ending July 2024. The July reading is significant, as it represents the first time since March 2021 that the 12-month CPI number dropped below 3%.¹

The Federal Reserve (Fed) has been closely monitoring inflation data as it sets monetary policy. The Fed raised the short-term fed funds target rate it controls by more than 5% between March 2022 and July 2023, but held rates at that level since. Fed rate hikes are intended to temper economic growth and consequently, slow inflation. This approach proved successful, given recent inflation trends.

“It appears the inflation environment continues improving,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Fed officials have indicated that they need to see multiple months of improvement before cutting rates, so ongoing inflation readings will be important as well,” says Haworth.

The Fed indicated as early as late 2023 that it could begin cutting the fed funds target rate in 2024 but has not done so yet. Markets now fully anticipate that the policymaking Federal Open Market Committee (FOMC) will initiate rate cuts at its mid-September meeting. The most recent CPI reading should serve to reinforce rate cut expectations. The question is whether the Fed’s initial rate cut will be 0.25% or 0.50%.²

While inflation has been the primary driver of Fed policy, Fed chair Jerome Powell recently indicated that interest rate decisions are also tied to labor market trends. “As the economy evolves, monetary policy will adjust in order to best promote our maximum-employment and price-stability goals,” Powell said. Just days after Powell made that statement, markets tumbled, in part responding to a weaker-than-expected labor market report that showed slowing job growth and rising unemployment. Some investors expressed concern that the Fed held the line on interest rates too long, putting the current economic expansion at risk. Powell made clear in recent comments that “we’re getting closer to the point at which it will be appropriate to reduce our policy (fed funds) rate.”⁴

Eric Freedman, chief investment officer for U.S. Bank Wealth Management, is looking for the Fed to provide more clear direction. “The Fed has to let markets know that ‘we get it, the economy is slowing, and consumers are feeling the impact’ of the higher fed funds rate.” Freedman says an open question now is to what level the Fed reduces the fed funds rate. “In 2000, it was near 7%. After the financial crisis of 2008, it was set around 1%. We think it is likely to settle at the mid-3% level,” says Freedman.

Inflation’s recent history

Over the past thirty years, living costs as measured CPI have grown by an average of 2.6% per calendar year. From 2000 through 2020, inflation never exceeded 4%, and in the previous decade (prior to 2021), living costs grew at a rate of 2% or less in most years. That changed in 2021, as inflation surged and Americans had to adjust to a different environment. In 2023, inflation began to return to what are more historically typical levels.³ The Federal Reserve Statement on Longer Run Goals articulates a long-term inflation target of 2%, as measured by the annual change in the personal consumption expenditure (PCE) price index.⁵

While higher costs for food and energy drove inflation’s surge in 2021 and 2022, those trends changed considerably in recent months, contributing to inflation’s slowdown. For the 12 months ending in July 2024, food costs rose just 2.2% while energy costs were up 1.1%. Continued areas of concern are rising shelter costs (up 5.1% for the 12-month period ending in July) and transportation services costs (up 8.8%).¹ “Some of the ongoing inflationary pressure comes from continued healthy wage gains for workers,” says Haworth, “The strong labor market is certainly contributing to the economy's strength and inflation’s persistence.”

As the inflation environment evolves, investors may be asking:

• Has inflation’s recent decline convinced the Fed that it’s time to start cutting interest rates?
• Are there risks that inflation could trend higher again?
• How should I position my investments given current inflation dynamics?

Looking beyond the headline numbers

Inflation is one primary Fed focus. As the country’s central bank, the Fed’s mandate is to promote full employment, stable prices and moderate long-term interest rates. In determining interest rate policy, an important measure the Fed monitors is “core” inflation (excluding the volatile food and energy sectors). In July 2024, core inflation rose 3.2% for the previous 12-month period, its lowest level since April 2021, representing the continuation of a modest but persistent downward trend.1 Nevertheless, core inflation remains well above the Fed’s 2% annual target.

“The Fed would clearly like to see core inflation come down,” says Haworth. More specifically, notes Haworth, the Fed is focused on core services costs excluding shelter costs. “Shelter costs are a lagging indicator, so the Fed tends to discount that data as it assesses service cost trends. Core services tend to be a good reflection of labor costs.” Haworth says the Fed is focused on seeing core services inflation slow.

The Fed’s preferred inflation gauge, the PCE price index, is a measure of the spending on goods and services. This number showed modest improvement in June, with the headline PCE index dropping to 2.5% for the previous 12 months, compared to 2.6% in May. The narrower “core” PCE (excluding the volatile food and energy categories) remained stable, rising 2.6% over the same period, matching May’s result.6 Both numbers remain above the Fed’s long-term 2% target.

Along with favorable CPI news, there continue to be encouraging developments at the wholesale price level. The main measure of changes to wholesale costs, the Producer Price Index, is up 2.2% over the past year and only 1.2% on a three-month annualized basis, as of July 2024.

Bond market impact

Bond yields, over long-term periods, tend to track the direction of inflation rates. Much of this may be related to Fed monetary policy responding to inflation trends. Since the Fed raised short-term interest rates, bond yields rose commensurately across the board. The benchmark 10-year U.S. Treasury note stood at 4.98% on October 18, 2023 then fell below 4% in late December as investors began to anticipate Fed rate cuts. For much of 2024, 10-year Treasury yields remained firmly above 4%, topping out at 4.70% in April as investors realized that Fed interest rate cuts weren’t on the immediate horizon. However, in early August, amid growing market confidence that the Fed will soon begin cutting rates, 10-year Treasury yields dropped below 4%. “The markets initially anticipated an early start to Fed rate cuts in 2024,” says Haworth. “Nevertheless, markets appear to believe that the Fed is on track to temper inflation, even if it takes a little longer than initially expected,” says Haworth.

How inflation can impact your portfolio

At a time when inflation began to slow from its peak in mid-2022, stocks performed better. In 2024, the S&P 500 has repeatedly reached record highs, though markets recently experienced more volatility. The bond market continues to offer attractive yields for long-term investors. Although yields on some shorter-term securities exceed yields of some longer-term bonds, Haworth says investors should consider placing more emphasis on their ultimate portfolio goals. “It may be an appropriate time to move money out of short-term vehicles and focus on positioning your portfolio in assets, such as stocks and longer-term bonds, that can help you achieve your ultimate financial objectives in the years to come.”

“We still think this is a grind-it-out, improving landscape for investors,” says Freedman. “Corporate profits are still intact and corporate spending remains robust.”

Haworth notes that the stock market has been on an upswing since late 2022. “In general, stock markets can perform well in either a high or low-rate environment, but it is periods of transition from one environment to the next that can cause more significant price swings.”

Haworth says the persistent inflationary environment creates challenges for bond investors. As a result, U.S. Bank’s Asset Management Group currently recommends investors tilt portfolios toward equities, with less emphasis on traditional fixed income.

Generally, a consistent long-term strategy tends to work to the benefit of most investors. This likely precludes any dramatic changes to your asset allocation strategy in response to today’s inflation environment.

Be sure to talk with your financial professional about what steps may be most appropriate for your situation.