Is CPI Rising Good or Bad?

Though inflation has come down from its highs a couple of years ago, January’s consumer price index (CPI) data still show it running hotter than economists expected.

Core CPI, which excludes food and fuel to limit the effects of more volatile commodities, rose 3.9% in January against economist expectations of 3.7%.

The fact that inflation is still higher than projected may prompt the Fed to keep interest rates higher instead of moving to implement rate cuts.

Higher rates are generally negative for stocks, as they increase the yields investors can realize on bonds and cash while diminishing the appeal of growth stocks.

The effects of inflation on the stock market and the economy, however, are more complex than interest rates alone.

Some Inflation Is Positive for Economic Growth

One of the first things for investors to understand about inflation is that a moderate level of it is positively associated with economic growth.

When economies grow, consumers experiencing rising wages typically increase their spending, thus putting additional demand pressure on goods and services. This increased demand puts modest upward pressure on prices, as supply often takes a while to catch up.

In the absence of this kind of growth cycle, prices, wages and inflation all tend to stagnate.

To illustrate this point, we need only look at the example of the Japanese economy over much of the last 40 years. Stagnant pricing since the end of the Japanese economic boom in the late 1980s resulted in essentially flat consumer spending and, by extension, flat wages for Japan’s workers.

This cycle of wage and price stagnation kept prices for consumer goods low but also hindered economic growth until very recently.

In recent years, Japan’s economy began to grow faster than at any time since the end of its aforementioned boom years. This growth coincided with the highest inflation rates since the 1980s, demonstrating the positive effects between moderate inflation and overall economic growth.

This leads to the question of how much inflation is the right amount. In the United States, the Federal Reserve assumes the ideal rate of long-term inflation to be around 2%.

Though there are valid criticisms of the methodology used to arrive at this figure, 2% inflation is generally seen as enough to keep advanced, mature economies growing at a healthy pace while also leaving room for interest rate cuts in the event of poor economic times.

Too Much Inflation Quickly Becomes Harmful

While a certain level of inflation is generally positive, inflation substantially above the 2% baseline begins to have harmful effects on consumers, businesses and the economic environment as a whole.

For investors, high inflation also eats away at returns by reducing the purchasing power of their dollars, resulting in lower real returns.

In large part, the negative effect of inflation is that businesses as well as consumers ultimately pay higher prices.

Costs of labor, real estate, basic materials, shipping, support services and a host of other business inputs all rise in an inflationary environment.

When this occurs, companies often must strike a balance between passing these higher prices on to consumers and accepting lower margins to avoid pricing themselves out of the market.

It’s worth noting here that not all stocks are affected by high inflation to the same degree. A general rule of thumb is that established consumer staples, utilities and other day-to-day necessities are resilient to inflation, while high-growth companies tend to suffer as consumers reduce their spending due to higher living expenses.

On the whole, however, higher inflation leads to lower corporate profit growth and, as a result, weaker performance across the stock market. Historically, earnings growth and inflation have had an inverse correlation when inflation moves outside of the 2-3% range.

At 4-6% inflation, for example, earnings growth slows from its low-inflation average of around 9% to roughly 7%.

Inflation in the 6-8% range creates an even more pronounced effect, lowering earnings growth to just over 5%.

Is a Rising CPI Good for Today’s Stock Market?

A rising CPI higher than 2% is typically considered negative for the stock market. In the United States at the moment, the CPI is rising at a level well above the 2% generally considered healthy.

Surprisingly, this rapid inflation hasn’t hindered the stock market over the last few years as one would generally expect. Not only has the stock market as a whole thrived during this period of higher inflation, but corporate profits have actively moved upward in conjunction with inflation.

One explanation for this phenomenon is the fact that Americans had significant excess savings following fiscal stimulus in recent years. These savings provided consumers with a counterbalance to inflation, allowing consumer spending to remain higher than it otherwise would have.

Wage growth stemming from a historically tight labor market may also have allowed workers to more easily keep pace with inflation for a time.

Although higher wages are also a known contributing factor to inflation, the economic recovery in recent years saw wage gains accruing to low-wage positions at a much higher rate than high-wage ones. As a result, the low-income consumers who are normally affected most by periods of higher inflation saw faster wage growth that at least partially offset the rising costs of goods and services.

Will Inflation Stay at Bay?

Unfortunately, neither one of these trends appears robust enough to keep the negative effects of inflation at bay indefinitely. Data from the Federal Reserve Board published in December of 2023 found that America’s excess savings from fiscal stimulus programs in the last few years had either already been depleted or would be soon. Meanwhile, the labor market has begun to ease and will likely continue to do so throughout 2024.

Further indicators of problematic inflation include a surge in consumer debt and a stark reduction of the American savings rate. Total consumer debt has risen to around $17.5 trillion, and both credit card and auto loan delinquencies are trending upward.

The personal savings rate, meanwhile, has fallen to 3.7%, far below the long-term average of about 8.5%. These factors point to growing strain on consumers’ finances and could suggest that consumer spending will fall or plateau in the near future.

It’s worth noting, however, that many observers still expect 2024 to be a year of modest economic growth in the United States. Expectations of a recession have eased, reducing concerns of a sudden drop in share prices.

While higher interest rates and weaker consumer spending could both be headwinds for growth, the current tailwinds appear to be somewhat stronger.

Ultimately, inflation and its effects are still negatives for the US economy and the stock market at the moment. However, they likely aren’t strong enough negatives to actively drive down the prices of most stocks unless additional economic pressures arise.

It’s more likely that persistent inflation could be a drag on otherwise strong share price growth, potentially resulting in somewhat less upside in equity markets this year. This is especially true in light of the fact that even last month’s higher-than-expected core CPI growth rate was below the range at which inflation has historically had its largest effect on corporate earnings growth.

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