Inflation Continues to Cool
June CPI registered a 3% increase, which was the smallest 12-month increase since the period ending March 2021. While a downward trend in inflation can always reverse, it is also possible that the easing inflation and a somewhat slower economy may result in the economic “soft landing” that the Federal Reserve has been attempting to engineer.
The June inflation report was anything but grim. In fact, it seemed to strongly suggest that we may be heading for a soft landing, which would mean a return to acceptable inflation without a large rise in unemployment. The economy is not there yet, but this outcome seems more likely after appearing to be only wishful thinking for much of the last year.
In terms of the economy, slower inflation is unquestionably good news, because it allows consumer paychecks to stretch further at the gas pump and in the grocery aisle. And if inflation can come down sustainably without a big increase in unemployment or a painful economic recession, it could allow workers to hang on to the major gains they have made over the past three years: progress toward better jobs and pay that has helped to chip away at income inequality.
And in terms of the stock and bond markets, slower inflation is also unquestionably good news, because it means the Fed can stop raising interest rates. Rising interest rates hurt both stock and bond values.
So what can still go wrong?
First, these favorable readings can always be revised, or prove to be an anomaly, taking away what appears to be good news. As Laura Rosner-Warburton, senior economist and founding partner at MacroPolicy Perspectives put it, “This is very promising news. The pieces of the puzzle are starting to come together. But it’s just one report, and the Fed has been burned by inflation before.”
Secondly, most estimates of underlying inflation are still running significantly above the Fed’s target. In other words, the Fed may still feel compelled to hike rates even further, which will slow the economy. In fact, most Fed watchers expect another one-quarter-point rate increase at the July 25-26 FOMC meeting, but view an additional hike in September as unlikely. After all, there is a meaningful lag between when the Fed changes rates and when those changes filter through the complexities of the economy.
Finally, we might get a recession even if we don’t need one to control inflation. So far the economy has proved remarkably resilient in the face of rising interest rates, but as just mentioned, monetary policy works with a lag, so there might still be a recession in the pipeline.
Outlook
An economic soft landing looks remarkably within reach. True, things can always deteriorate, but the economy is on solid footing at this point. There has been a surge in job creation, which has reversed pandemic job losses and resulted in an unemployment rate of only 3.6%, making this arguably the best job market in a generation.
The 2021-22 burst of inflation was a shock, but if it turns out to have been temporary and ends without major suffering, it will be hard to avoid the conclusion that recent economic performance has, all things considered, been pretty darn good.
Stock Market
The stock market has responded favorably to the latest inflation news, but predicting what the stock market might do in the short run is usually a fool’s errand. Warren Buffet, arguably the greatest investor, rarely, if ever, gives stock market predictions except to say that the stock market will go up over long periods of time. Patience, grit and resolve is what is needed to succeed as an investor, not a crystal ball.
That being said, this does seem to be a slightly better-than-average time to be invested in the stock market for a few reasons. First, no one is very excited about the stock market. To quote the great investor, “Be fearful when others are greedy.” The point here is that people tend to get excited (and greedy) about the stock market after it has already made a run higher, not before. And, although the stock market is up handsomely this year (roughly 18%), it is still below the highs reached a year and a half ago in January 2022. Investors remain somewhat skeptical after a bruising 2022. This distrust of the market usually bodes well for future gains.
Secondly, the credit cycle may be turning. One of the best predictors of stock market direction is the direction of interest rates. Another legendary investor, Marty Zweig, coined the term, “Don’t fight the Fed.” What is meant by this is that the stock market will be under pressure if the Fed is raising interest rates. This certainly held true during 2022 as the Fed aggressively raised interest rates to fight inflation and the stock market fell. However, inflation is cooling and it seems likely that the Fed can pause its rate hikes, which should help stock prices.