Whether you realize it or not, it's a big day for Wall Street and investors. At 8:30 a.m. ET, the U.S. Bureau of Labor Statistics (BLS) will release the July 2023 inflation report.
Most consumers probably don't need an inflation report from the BLS to tell them that the price of the goods and services they regularly buy has increased over the past year. Nevertheless, this all-encompassing monthly released inflation report often serves as the foundation that guides the Federal Open Market Committee (FOMC) in their monetary policy decision-making.
Image source: Getty Images.
The question on the minds of investors is whether the Federal Reserve is set to continue raising interest rates to tame above-average inflation or if it'll finally sit on its proverbial hands and allow the impact of a cumulative 500 basis points of federal funds rate increases to filter their way into the U.S. economy.
Based on the data we have now, one telltale chart appears to be giving away the answer.
The U.S. inflation rate, based on the CPI-U, has noticeably tapered
Let me state straight away that the FOMC's "Summary of Economic Projections," which is better known as the "dot plot," isn't the chart I speak of. Although the dot plot does provide a visualization of where voting and non-voting FOMC participants believe the federal funds rate will be this year, as well as one and two years from now, it's highly fluid and subject to change, based on economic data.
For instance, the dot plot in March 2022 suggested the federal funds rate would hit roughly 3% this year, with a peak estimate ranging from 3.5% to 3.75%. We're currently at 5% to 5.25%, to put these forecasts into perspective.
U.S. Inflation Rate data by YCharts.
On one hand, the all-encompassing U.S. inflation rate, as determined by the Consumer Price Index for All Urban Consumers (CPI-U), has fallen well off of its June 2022 peak of 9.1%. While the 3% year-over-year increase registered in June 2023 still signals that prices for a broad basket of goods and services are rising, they're doing so at a far more modest pace -- which is what the nation's central bank would prefer to see.
This significant drop-off in the CPI-U over the trailing year has primarily been fueled (cue the irony) by fuel, as well as food. Over the trailing 12 months (TTM), energy expenses have, collectively, declined by 16.7%, led by a 26.8% drop in energy commodities, which includes all types of gasoline and fuel oil.
Though the unadjusted TTM inflation rate for food is still an above-average 5.7%, seasonally adjusted changes since March 2023 show a rapid decline in the pace of rising prices for food.
This chart speaks volumes about the Fed's decision on interest rates
However, the CPI-U, in its entirety, isn't what the FOMC is considering when it decides whether or not to continue raising interest rates. The chart that seems to have already given away what the Fed plans to do is that of core inflation.
"Core inflation" strips out food and energy costs, since they tend to be quite volatile, but accounts for every other major spending category within the CPI-U. Core inflation tends to be a far better (and stabler) measure of the inflationary pressures the typical consumer is facing.
U.S. Core Inflation Rate data by YCharts.
As you can see from the chart above, core inflation hasn't come anywhere close to normalizing. Although it's backed off its year-ago high of 6.6%, the June 2023 reading of 4.8% is considerably higher than anything we've consistently seen in 32 years.
Shelter costs -- the expenses associated with owning or renting a home -- have been particularly stubborn, with an unadjusted TTM inflation rate of 7.8%, as of June 2023. A significant surge in mortgage rates has tightened new home supply, as well as given landlords and apartment communities substantial power to increase rent. Shelter is the single biggest component of the CPI-U and core inflation.
Even though the core inflation rate has been modestly trending lower since September, the fact that it remains so decisively above its historic norm strongly suggests the Fed will continue its rate-hiking cycle.
Investors shouldn't fear rate-hiking cycles
Most investors view rate-hiking cycles from the Fed as negative for the stock market.
If the nation's central bank is raising interest rates, it makes borrowing costlier, which should, in theory, reduce the desire of businesses to borrow, slow hiring, and potentially curb innovation and acquisitions. In other words, higher interest rates tend to slow economic growth, which eventually translates into slower corporate earnings growth.
Interestingly enough, though, Federal Reserve rate-hiking cycles have generally been bullish for Wall Street.
The S&P 500 is now up close to 5% since the Fed started hiking in March '22.
-- Ryan Detrick, CMT (@RyanDetrick) July 26, 2023
It is actually perfectly normal for stocks to gain during periods of rate hikes. Sure, this time was anything but normal with a vicious bear market in the middle.
Still, this is interesting. pic.twitter.com/9cmCYl55N9
As shown in the post above from Ryan Detrick, Chief Market Strategist at Carson Group, there have been 12 instances over the past 77 years where the nation's central bank has raised its federal funds target rate at least five times. Note, Detrick's example makes the assumption that the current rate-hiking cycle ended in July.
Nine of these 12 rate-hiking cycles saw the benchmark S&P 500 (^GSPC +1.20%) head higher. Even accounting for the three cycles that resulted in negative returns, the S&P 500 has averaged a 10.6% return from the beginning to the end of each rate-hiking cycle.
What should actually have investors cautious is rate-easing cycles. Since the start of the century, the Fed has undertaken three rate-easing cycles, which respectively began on Jan. 3, 2001, Sept. 18, 2007, and July 31, 2019. In all three instances, the Dow Jones Industrial Average (^DJI +1.79%), S&P 500, and Nasdaq Composite (^IXIC +1.52%) subsequently fell into a bear market.
In the same order I've listed the initial rate-reduction dates above, the benchmark S&P 500 didn't bottom out until a respective 645 calendar days, 538 calendar days, and 236 calendar days later. Put another way, the broader market hasn't bottomed out this century, on average, until well over one year after the Fed began easing interest rates.
Image source: Getty Images.
But to tie things up in a neat bow, trying to time directional moves in the Dow, S&P 500, and Nasdaq, based on Fed interest-rate decisions, is somewhat pointless if you're a long-term investor. While the major indexes will, undoubtedly, endure "hiccups" getting from Point A to B, the Dow Jones, S&P 500, and Nasdaq Composite have proved infallible when examined over multidecade periods.
Regardless of whether the Fed continues to hike, as the core inflation chart suggests it will, or declares an end to the current hiking cycle, high-quality stocks and Wall Street's representative indexes will be just fine.
