Analysis: Assessing inflation’s impact

What has been a fairly stable inflation picture, with the annual change in living costs stuck in a range between 3.0% and 3.7% for more than a year, took an encouraging turn in June. Inflation as measured by the Consumer Price Index (CPI) was down for the month, and the inflation rate for the previous 12-month period dropped to 3.0%. That represents its lowest reading since June 2023, and continued a modest downward trend.¹

“It appears the inflation environment is slowly improving,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. Markets pay close attention to inflation data to see if it may provide a green light for the Federal Reserve (Fed) to begin lowering the federal funds target interest rate it controls. “Fed officials have indicated that they need to see multiple months of improvement before cutting rates, so upcoming inflation readings will be important as well,” says Haworth.

Inflation’s resurgence, beginning in 2021, was the impetus behind a significant change in Fed monetary policy. It prompted the Fed to raise the fed funds target rate from near 0% to a top level of 5.5%. The Fed has held rates at that level since July 2023. While markets anticipated the Fed would reverse course in 2024 and begin cutting rates, inflation’s decline flattened out beginning in mid-2023, and only recently began modestly trending lower.

How influential will the latest CPI data be as the Fed assesses its interest rate policy? Fed chair Jerome Powell recently stated, “Inflation is not the only risk we face. Reducing policy restraint (interest rates) too late or too little could unduly weaken economic activity and employment.”³ While not yet a ringing endorsement of an immediate interest rate reduction, it indicated that the Fed is concerned not just about persistent inflation, but the possibility of an economic slowdown. Markets today are pricing in the high likelihood that the Fed will initiate fed funds target rate cuts at its September 17-18 meeting.⁴

“Markets will keep a close eye on whether the Federal Open Market Committee sets expectations at its July meeting that a September rate cut is on its radar,” says Haworth. “The Fed has in the past tended to affirm market expectations, rather than to take actions that catch the market off guard.”

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.² 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 June 2024, food costs rose just 2.2% while energy costs were up 1.0%. Energy costs declined in both May and June. However, rising shelter costs are among the biggest contributors to persistent inflation. For the 12-month period, shelter costs are up 5.2%, with overall services costs (less energy services) up 5.1% over that period.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:

• 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 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 June 2024, core inflation rose 3.3% for the previous 12-month period, its lowest level since April 2021, representing a modest drop from May’s 3.4% reading.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 May, with the headline PCE index dropping to 2.6% for the previous 12 months, compared to 2.7% for the prior two months. The narrower “core” PCE (excluding the volatile food and energy categories) provided encouragement, rising 2.6% over the same period, following three consecutive months at 2.8%.⁶ Both numbers remain 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” has made the Fed cautious about beginning rate cuts. Given inflation’s persistence in the 3% range and an economy that has proved resilient despite higher interest rates, “There’s been enough cover for the Fed to sit tight,” says Freedman.

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, 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. “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. 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, 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 persistently elevated inflation.

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