Analysis: Assessing inflation’s impact

Inflation, considered one of America’s most visible economic concerns and a data point closely watched by investors, continues its decline based on U.S. Bureau of Labor Statistics data in the Consumer Price Index (CPI). The latest reading shows that for the 12 months ending in August, CPI, a benchmark inflation measure, rose 2.5%. It’s a significant improvement over the previous month’s reading of 2.9%. It represents an encouraging trend after inflation remained at 3% or higher for more than a year, and it marks a significant drop from its peak of 9.1% in mid-2022.¹

“This appears to add one more piece of data to the puzzle that the Federal Reserve (Fed) is trying to solve in terms of its interest rate policy,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “They want to see the trend of slower inflation continue, perhaps giving them more leeway to address concerns about the slowing labor market.”

While markets anticipated that Fed rate cuts might start in early 2024, the Fed held the line. Markets today project more confidence that the Fed will cut rates multiple times between now and the end of 2024, and perhaps beyond.² Fed Chair Jerome Powell’s recent statements indicate that the Fed will begin the process at its mid-September meeting.³

Since 2021, inflation was the primary driver of Fed policy. Powell now indicates that interest rate decisions will also consider labor market trends. A primary concern is the recent rise in the nation’s unemployment rate to 4.3%. While historically low, over the past year the unemployment rate has trended higher.4 Appearing to respond to the concern, Powell recently stated, “The time has come for (interest rate) policy to adjust.”³

Markets experienced significant volatility, first in early August, then again in September. This appeared to reflect investor concerns that the Fed maintained higher interest rates for too long, putting the current economic expansion at risk.

Eric Freedman, chief investment officer for U.S. Bank Wealth Management, says an open question now is to what degree 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. For now, says Freedman, “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.”

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 (notably, in August 2024, it dropped just below that level). 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. Inflation has now returned to more historically typical levels.⁴ 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 food and energy costs drove inflation’s surge in 2021 and 2022, the trend has eased. For the 12 months ending in August 2024, food costs rose just 2.1% while energy costs declined by 4.0%. Continued areas of concern are rising shelter costs (up 5.2% for the 12-month period ending in August) and transportation services costs (up 7.9%).¹

As the inflation environment evolves, investors may be asking:

• Will lower inflation spur deeper Fed interest rate cuts?
• 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 has always been a 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 August 2024, core inflation rose 3.2% for the previous 12-month period, matching July’s rate, which was the lowest level since April 2021. Rising shelter costs helped keep core inflation elevated.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 was steady in July, with the headline PCE index at 2.5% for the previous 12 months. The narrower “core” PCE (excluding the volatile food and energy categories) has held constant for three consecutive months, at 2.6% through July.⁶ Both numbers remain above the Fed’s long-term 2% target.

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. Rates rose again in 2024’s opening months, topping out at 4.70% in April as investors realized that Fed interest rate cuts weren’t on the immediate horizon. 10-year Treasury yields dropped below 4% in early August and continued trending lower since.

How inflation can impact your portfolio

Once 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, but yields declined from peak levels. 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’s 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.”

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.