The U.S. Federal Reserve is responsible for keeping inflation in check by ensuring the Consumer Price Index (CPI) doesn't deviate too far from its 2% annual target. The CPI measures the change in price of a basket of goods and services by comparing it to a previous point in time.
Large swings in the CPI above or below 2% will prompt the Fed to adjust the federal funds rate, which directly impacts interest rates. This can have serious consequences for consumer spending, corporate profits, and the price of assets like stocks and real estate.
The CPI climbed to a 40-year high in 2022, forcing the Fed to rapidly raise interest rates to cool the economy. That policy response appears to be working, because inflation fell significantly in 2023, and the latest data shows the momentum has continued into the early months of 2024.
We haven't witnessed comparable declines in inflation since 2009, and on that occasion, it sparked one of the longest winning streaks for the S&P 500 (^GSPC 1.02%) in stock market history. Here's why it could happen again.
The pandemic created an inflationary environment
A number of things can trigger a sharp rise in inflation:
- Loose monetary policy in the form of low interest rates and a rapidly increasing money supply.
- Stimulative government policies with heightened spending.
- Economic shocks that disrupt supply chains, causing prices to artificially rise for periods of time.
All of those things showed up at the height of the pandemic during 2020 and 2021. Manufacturing hubs shut down around the world to stop the spread of COVID-19, the U.S. government spent trillions of dollars to stimulate the economy, and the Fed cut rates to a historic low of 0% to 0.25% while injecting trillions of dollars into the financial system through quantitative easing (QE).
As a result, it's no surprise the CPI saw its year-over-year change soar to 8% in 2022, which was the highest level since 1981.
Peak inflation is almost certainly in the rearview mirror
The Fed acted quickly in response to the CPI's spike, raising the federal funds rate all the way to a range of 5.25% to 5.50% over the 17-month span from March 2022 to August 2023. However, many investors still abandoned the stock market in favor of safer assets like U.S. government Treasury bonds, which sent the S&P 500 plunging 18% in 2022.
Thankfully, the CPI's year-over-year change fell to 4.1% in 2023, which reignited investors' optimism and sent the S&P 500 soaring by 26.3% for the year.
The Fed doesn't plan to raise the federal funds rate any further, and it has indicated three rate cuts might be possible this year. Wall Street is a little more optimistic, predicting there could be four cuts.
Another spike in inflation would change the calculus entirely. However, that is unlikely given how high interest rates have risen, and because the Fed has pulled $1.4 trillion out of the financial system since 2022 as it attempts to reverse the effects of QE.
Image source: Getty Images.
2009 and 1982 delivered similar declines in the rate of inflation
The 3.9-percentage-point decline in the inflation rate in 2023 was the steepest since 2009, and 1982 prior to that.
A housing bubble began to inflate in the early 2000s, which drove excessive borrowing and heightened economic activity. The CPI's rate of change began to tick higher in 2002, and the Fed tried to tame the situation by raising interest rates between 2004 and 2006. The inflation rate finally peaked at 3.8% in 2008, but it probably had more to do with the bursting of the housing bubble, which crushed the economy. It also sent the S&P 500 plunging 37% for the year.
By 2009, the inflation rate slipped into deflation territory with a reading of negative 0.4% (a decline of 4.2 percentage points from 2008). The Fed was already slashing the federal funds rate to counteract the global financial crisis, and it spent all of 2009 at a historic low of 0.25%. Despite the chaos, the S&P 500 rebounded with a convincing gain of 26.5% for the year.
Simply put, cash yields no return when the federal funds rate is near zero, so investors instead put their money into growth assets like stocks.
A similar phenomenon was observed in the early 1980s. The CPI's annual change peaked at 13.5% in 1980 before falling to 10.3% in 1981, and then 6.1% in 1982, following an aggressive increase in interest rates from the Fed. Rates then started to decrease alongside the drop in the inflation rate, and the S&P 500 recorded a gain of 21.5% in 1982 after ending the prior year in the red.
The S&P 500 just entered a new bull market, and it could be a long one
2009 and 1982 featured their own unique circumstances, but the decline in inflation (and interest rates) had a positive effect on the stock market on both occasions. 2009 marked the beginning of a nine-year winning streak for the S&P 500, which is tied for the longest in history. Similarly, 1982 was the beginning of an eight-year winning streak.
The S&P 500 is in a new bull market right now, and if history is any guide, it could be a lengthy one. The latest inflation data showed a continued decline in the CPI's change in January, coming in at an annualized rate of 3.1%. The trend toward the Fed's 2% target is clear, and so long as it persists, interest rates are almost certain to fall.
Lower rates will reduce the cost of capital for businesses and potentially fuel a wave of corporate investment. That could drive faster earnings growth, which gives investors more reason to own stocks, especially as the yield on cash will decline at the same time.
The S&P 500 had a strong year in 2023, and it might have marked the beginning of a multiyear winning streak. It's off to a hot start in 2024, with a 9% gain so far.
