The Fed’s Inflation Target is Not Yours

The Fed’s Inflation Target is Not Yours

October 02, 2023

Investors waiting for the magic 2% may miss the boat

Inflation matters in many ways, but seemingly the most important factor for markets today is the force behind the Federal Reserve’s actions.  The Fed’s primary tool to cool inflation is higher interest rates.  Higher rates potentially pass through to slower economic growth and may apply additional pressure on fixed income and equity prices.  So, in some ways in our current environment, the sun rises and sets on inflation as a matter of importance.

As we outlined in our Outlook at the beginning of the year, and reiterated in our recent Mid-Year Update, we believe inflation will continue to slow, but it is likely to be a bumpy road.  Our view remains that inflation is on the right path, but it may not be a straightforward path.

Inflation, like many other economic figures, is reported monthly and on a lag (i.e., September CPI is reported in October).  As a result, when we read about annual inflation, we are looking at 12 data points, the oldest of which is measuring data 13 months old, the youngest of which is one month old.  Over the last year we have experienced very high measures of inflation and also moderating inflation.  It stands to reason, then, that annual (12 month) inflation may be overstating the recent trend and level of inflation which in turn could have a meaningful impact on how markets and the Fed react.

As we know, the Fed’s long-term inflation target is 2%.  For investors, however, that is not our target (at least for now).  Our target should be a rate and trend of inflation that allows the Fed to stop, or at least pause, hiking rates.  In all eight rate hiking cycles since 1974, the Fed stopped raising rates when inflation was above 2%.  And if more recent inflation trends persist, the inflation rate could quickly fall below the Fed Funds rate, which historically has been a common signal to stop hiking.  

The recent narrative is that the Fed is willing to keep rates “higher for longer” due in part to relatively favorable economic data and more positive sentiment on the potential for a soft landing.  Equities rallied through most of this year due to expectations of potential Fed rate cuts by year end but have experienced much more volatility as the narrative shifted to the “higher for longer” story as the year progressed.  Fixed income markets are more directly impacted by rising rates, as bond prices move inversely to interest rates, and therefore have also been experiencing heightened volatility recently. 

But as we know with most financial markets, those that choose to wait for the “all-clear horn” may miss opportunities.  While volatility is likely to continue, we believe that portfolios which are thoughtfully constructed to provide resiliency in a variety of market scenarios should position investors to meet their long-term objectives.

The views expressed represent an assessment at a specific point in time, are opinions only and should not be relied upon as investment advice regarding investments, strategies, sectors or markets in general. 

 The above commentary has been obtained from sources we believe are reliable, but we cannot guarantee their accuracy or completeness.  Past performance is no guarantee of future results.  This is not a complete analysis of every material fact.  All expressions of opinion are subject to change without notice.

 The information contained in this document does not constitute the rendering of legal, accounting, or other professional advice or opinions on specific facts or matters.  Talk to your financial advisor before acting on information in this document.