Inflation is an important economic indicator, and understanding its impact can help investors make more informed decisions. It's measured by the Consumer Price Index (CPI), which tracks the change in price of a basket of goods and services over time.
The U.S. Federal Reserve is tasked with controlling inflation, which normally means a CPI increase of 2% each year. Big moves above or below that inflation target can have serious implications for asset prices, from stocks to housing.
Last year, the CPI fell by the largest amount since 2009. The 2009 instance marked the beginning of one of the longest winning streaks for the S&P 500 (^GSPC 1.02%) index in stock market history. Could it happen again?
The pandemic triggered a surge in inflation
The U.S. government and the Fed took drastic action when the COVID-19 pandemic struck in 2020. Congress approved trillions of dollars in stimulus spending, and the Fed slashed the federal funds rate to a historic low of 0.25%. It also implemented quantitative easing (QE) to inject capital into the financial system.
The goal was to save the economy from collapse, and those initiatives largely succeeded. But when vaccines were introduced and social restrictions were lifted, the economy was still awash with stimulus cash combined with low interest rates, which drove an uptick in inflation in late 2021.
That was compounded by supply chain issues still working their way through the economy. Manufacturing hubs around Asia were still dealing with lockdowns, leading to shortages of products like cars, which sent prices soaring.
Those conditions led to a chaotic 2022, with the CPI surging to a 40-year high of 8%. It drove the Fed to increase interest rates aggressively, taking the federal funds rate from 0.25% to 5.50% in just 18 months starting in March 2022.
Investors feared that the soaring CPI and higher interest rates would pressure consumer spending, which, in turn, would lead to sluggish corporate earnings. As a result, the S&P 500 ended 2022 with a loss of 18%.
Inflation just fell at the fastest pace since 2009
The move to rapidly increase interest rates to tame inflation appears to be working. In 2023, the CPI was 3.5%, which marked a steep drop of 4.5 percentage points from 2022. It triggered a rebound in the S&P 500 and logged an impressive gain of 26.4% for the year.
The last time the CPI fell that much was in 2009. The CPI was slightly above the Fed's 2% target in 2003, but it steadily climbed until 2008, when it hit 3.8%. It was driven by a real estate bubble, which the Fed tried to tame by raising the federal funds rate from 1.25% to 5.25% between 2004 and 2006. But the global financial crisis followed, driving a collapse in the banking system (and the broader economy).
In 2009, that caused the CPI to dip into deflation territory with a reading of negative 0.4%. It marked a drop of 4.2 percentage points from 2008. Again, the Fed sprang into action during the crisis by slashing rates to a historic low of 0.25%, and it introduced QE for the first time to prop up the financial system.
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2009 was the start of a historic winning streak for stocks
The financial crisis sent the S&P 500 plunging 37% in 2008. However, the Fed's aggressive policy actions instilled confidence in investors, and the market rebounded in 2009 with a gain of 26.4%.
Given the extent of the crisis, few investors predicted 2009 would mark the beginning of a nine-year bull run in the S&P 500, which is tied for the longest in history dating back to 1926. But that's exactly what happened.
It was driven by a goldilocks economic scenario where inflation remained within the Fed's target despite the central bank injecting $4 trillion into the financial system through QE between 2009 and 2014. Plus, through the entire bull run (ending in 2018), the federal funds rate never exceeded 2.50%, given inflation remained so stable.
Many of those factors are absent today. The federal funds rate stands at 5.50%, and the Fed is in a state of quantitative tightening (the reverse of QE). It has pulled roughly $1.3 trillion out of the financial system over the last 18 months. On the other hand, the economy isn't facing a disaster like it was in 2009 with the financial crisis.
There's another historical analog to the current situation. The CPI soared in the 1980s, peaking at 13.5% in 1980 before falling to 10.3% in 1981 and then 6.3% in 1982, thanks to an aggressive policy response from the Fed.
That drop in inflation led to lower interest rates, and 1982 triggered an eight-year bull run in the S&P 500, even without tailwinds like QE. That could be a sign of things to come, so long as the CPI moves closer to the Fed's 2% target this year.
Interest rates are likely to fall in 2024, which could drive stocks higher
Given the CPI result in 2023, Wall Street predicts the Fed will cut interest rates six times this year. That could ease some of the financial pressures on households and boost corporate earnings, as businesses can afford to borrow more money to fuel growth. Both factors are great for the stock market.
Plus, holding cash becomes less attractive as interest rates fall, pushing more investors into stocks. After all, the S&P 500 has delivered an average return of 10.2% (including dividends) since it was established in 1957; even with the rise in the federal funds rate since 2022, cash is yielding only between 4.0% and 5.5% in most cases, depending on whether you invest in Treasury bonds or bank deposits.
With that in mind, 2023 may very well have kicked off another multiyear bull market in the S&P 500. However, that scenario hinges on the CPI falling to 2% and holding there for the Fed to slash interest rates. The economy must navigate a series of geopolitical conflicts across Europe and the Middle East that could potentially affect energy prices. Oil and gas prices impact any product that must be shipped, flown, or trucked across the world, which feeds into the CPI.
Nevertheless, investors should always take a long-term view of the stock market because most challenges are short-lived. Not even the pandemic kept the market down in 2020, and that was a once-in-a-century event.
