Why Wall Street's Inflation Celebration Proved Short Lived

Investors don't like September, and this year's stock market performance during the month explains why. After having climbed early Friday, stock markets finished poorly, with only the Nasdaq Composite (^IXIC 2.02%) managing to post a modest gain on the day. Losses for the S&P 500 (^GSPC 1.02%) and Dow Jones Industrial Average (^DJI 0.40%) only exacerbated sizable declines for the month and for the third quarter.

Data source: Yahoo! Finance.

Early on, markets rose as one measure of inflation suggested the potential for relief for consumers. Yet a closer look at the report made it clear that expectations for inflation remain at heightened levels, and there might not be a quick resolution in sight. Indeed, with energy prices on the rise, there could be more bouts of higher inflation before things settle down.

Personal-consumption expenditures show easing inflationary pressure

The good news on Friday morning came from the Commerce Department, which released economic data that included information on personal-consumption expenditures (PCE). In particular, the Federal Reserve looks closely at the PCE price index, which it sees as a more accurate gauge of inflation than the Consumer Price Index.

The PCE price index climbed 0.4% in August, which wasn't necessarily good news. However, much of that gain came from a rise in energy costs. The core PCE price index, which excludes food and energy prices, was up just 0.1% during the month. It's that core reading that the Fed seems to prefer, given the volatility in the categories that it excludes.

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Investors have been pleased to see inflation levels come down steadily over time. With August's number, the 12-month rise in the core PCE price index declined to 3.9%, down from 4.3% in July. The broader PCE price index that includes food and energy was up 3.5% from 12 months ago.

But inflation remains stubborn

The problem, though, is that these readings remain far above the Fed's 2% inflation target. Moreover, they reflect the fact that at least in part, high inflationary expectations have become somewhat entrenched in the economy.

Most economists have focused on the fact that annual inflation rates were as high as 9% not long ago. In that light, a drop to around 4% is notable. However, if price increases came about because of a one-time shock to the economy related to the COVID-19 pandemic, then economists would expect those steep increases to end once the one-time event fell out of the trailing-12-month comparisons.

In other words, by that argument, inflation should be back to 2% already. The fact that it's not means that there could be a bigger challenge for Federal Reserve policymakers than market participants currently recognize.

What lies ahead

For the most part, market participants focused on the near-term impact that the inflation reading could have on the Fed's monetary policy decisions. Having taken no action to change rates at its September meeting, the Federal Open Market Committee is expected to do one more quarter-point boost either in November or in December. If the Fed interprets the latest inflation data as encouraging, then that might motivate policymakers to hold off on a rate increase in November.

The counterargument, though, is that rates on longer-term bonds have started to move higher. With 10-year Treasury bonds yielding more than 4.5%, the impact on the economy could start to be more palpable. Mortgage rates tend to get tied to longer-term rates like the 10-year rather than to the Fed-controlled federal funds rate, and already, housing activity has cooled markedly.

If inflation keeps declining, then it would be good news for the stock market. But if inflation levels remain at these elevated levels of 3% to 4%, then it would signal that price pressures won't just go away without a real fight. That's what investors seemed to fear on Friday, and it could be a while before the situation resolves itself.