Analysis: Assessing inflation’s impact

The change to the cost-of-living, as measured by the Consumer Price Index, remains nearly stagnant, stuck above 3% for the 11th consecutive month as of April 2024. While inflation over the previous 12 months dropped to 3.4% in April from March’s 3.5% reading,¹ it demonstrated that the pace of inflation remains a challenge to Federal Reserve (Fed) policymakers.

The Fed has been focused on reducing inflation with a series of 11 interest rate hikes implemented between March 2022 and July 2023. The Fed's actions appeared to have the desired impact, as inflation slowed considerably. That prompted the Fed to raise the possibility of rate cuts in 2024. However, inflation’s stickiness is dampening expectations for rate cuts in the near term.

“What we continue to see is that the Fed will hold interest rates higher for longer,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. Fed chair Jerome Powell seemed to confirm this, indicating that April inflation readings “were higher than I think anyone expected. What that has told us is that we’ll need to be patient and let restrictive policy (higher interest rates) do its work,” said Powell. “I do think it’s really a question of keeping (interest rate) policy at the current rate for longer than had been thought.”²

Over the past thirty years, inflation as measured by CPI has averaged 2.6% growth 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.⁴

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 April 2024, food costs rose just 2.2% while energy costs were up 2.6%. However, rising shelter costs are among the biggest contributors to February’s higher inflation. For the 12-month period, shelter costs are up 5.5%, with overall services costs (less energy services) up 5.3% over that period.² “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:

• When will inflation drop to the Fed’s 2% target?
• 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 a primary focus for the Fed. 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 April 2024, core inflation rose 3.6% for the previous 12-month period, its lowest level in three years, but little changed so far in 2024.¹ Core inflation remains well above the Fed’s 2% annual target.

“Core inflation remaining higher is another sign that the Fed is likely to push interest rate cuts farther into the future,” says Haworth. Contributing to the expectation of rate cut delays was April’s Producer Price Index (PPI) report, measuring wholesale costs for raw, intermediate and finished goods. PPI for the 12 months ending in April rose 2.2%, its highest reading in a year, another sign that inflation’s decline from this point is not happening as quickly as many would like.⁵

The Fed’s preferred inflation gauge, the PCE price index, is a measure of the spending on goods and services. This again offered little encouragement for investors eager for the Fed to begin cutting rates. The headline PCE index ticked up to 2.7% for the one-year period ending in March 2024 (compared to 2.5% in February and 2.4% in January). The narrower “core” PCE (excluding the volatile food and energy categories) rose 2.6% over the same period, a slight drop from February.⁶ Again, both numbers are well above the Fed’s long-term 2% target.

“To this point, the Fed remains firm that it wants to see inflation down to its 2% target,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management. Freedman says inflation’s “stickiness” makes the Fed somewhat cautious about when it begins cutting interest rates. Given inflation’s persistence in the 3% range and an economy that has proved resilient despite higher interest rates, “There’s enough cover right now for the Fed to sit tight,” says Freedman.

The Fed’s preferred inflation gauge, the PCE price index, is a measure of the spending on goods and services. This again offered little encouragement for investors eager for the Fed to begin cutting rates. The headline PCE index ticked up to 2.7% for the one-year period ending in March 2024 (compared to 2.5% in February and 2.4% in January). The narrower “core” PCE (excluding the volatile food and energy categories) rose 2.6% over the same period, a slight drop from February.6 Again, both numbers are well above the Fed’s long-term 2% target.

“To this point, the Fed remains firm that it wants to see inflation down to its 2% target,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management. Freedman says inflation’s “stickiness” makes the Fed somewhat cautious about when it begins cutting interest rates. Given inflation’s persistence in the 3% range and an economy that has proved resilient despite higher interest rates, “There’s enough cover right now for the Fed to sit tight,” says Freedman.

The fed funds target rate, managed by the Fed’s policy-making Federal Open Market Committee (FOMC), is 5.25% to 5.50%, up from close to 0% as recently as two years ago. The Fed has maintained the target rate at that level since July 2023. In that time, bond yields rose commensurately across the board. The benchmark 10-year U.S. Treasury note stood at 4.98% on October 18, then fell below 4% in late December as investors began to anticipate Fed rate cuts. However, 10-year Treasury yields have, in 2024, remained firmly above 4%. “The markets initially anticipated an early start to Fed rate cuts in 2024,” says Haworth. The latest data appears to dampen expectations for interest rate cuts until later in the year. “Nevertheless, markets appear to believe that the Fed is on track to temper inflation, even if it takes a little longer than initially expected.”

How inflation can impact your portfolio

At a time when inflation began to slow from its peak in mid-2022, stocks performed better. In early 2024, the S&P 500 stock index reached new highs. While bond yields are below peak levels reached in October 2023, 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 may not yet be seeing the massive disinflationary environment many are looking for,” says Freedman, “but’s it’s still an environment where we think you can own stocks, as opposed to getting more bearish.”

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 some challenges for bond investors. As a result, U.S. Bank’s Asset Management Group currently recommends investors tilt portfolios toward equities and real assets and away from 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 persistently elevated inflation.

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