The Most Important Debate on Wall Street: Is Inflation Licked? | Mint

The Most Important Debate on Wall Street: Is Inflation Licked?

Jerome Powell, chairman of the US Federal Reserve. The Fed raised interest rates to the highest level in 22 years and left the door open to additional increases as officials fine-tune their effort to further quell inflation. (Photo: Bloomberg)
Jerome Powell, chairman of the US Federal Reserve. The Fed raised interest rates to the highest level in 22 years and left the door open to additional increases as officials fine-tune their effort to further quell inflation. (Photo: Bloomberg)

Summary

Not everyone is sure it is coasting to the Fed’s target rate.

Most of Wall Street thinks inflation has been conquered. There is a lot at stake if they are wrong.

Encouraging inflation data recently propelled a big rally across markets, with a traditional portfolio of stocks and bonds last month delivering one of its best returns of the past 30 years.

Confident that the Federal Reserve is now cruising to its goal of 2% inflation, investors have dialed up bets that the central bank will start cutting interest rates by spring to prevent a recession. That would mark the end of an inflation-fighting campaign that has rattled markets since early 2022.

Still, the Fed’s preferred inflation gauge remains elevated at around 3%. And some investors are concerned it could be hard to get all the way back to 2%, leaving stocks and bonds vulnerable to a pullback.

Here is a deeper look at the arguments for and against inflation optimism.

The case for optimism

There are many ways to measure inflation.

The Fed’s official mandate is to target 2% inflation as measured by the 12-month change in the personal-consumption expenditures price index.

In practice, Fed officials tend to focus on the core PCE index, which excludes volatile food and energy categories. They also track three- and six-month price changes to understand more-recent dynamics.

Those figures are what have excited investors. Across 12 months, core PCE inflation was still around 3.5% in October. But on a three-month annualized basis, it was just 2.4%.

Some analysts say inflation is likely to keep declining as pandemic-era effects continue to fade.

A big driver of inflation in 2021 and 2022: Everyone was spending money on the same things at the same time. First it was on goods, when people were stuck at home and flush with government-stimulus money. Then it was on services such as travel and eating out, once Covid fears subsided.

Now “that singularity of behavior has really dissipated," resulting in less pressure on both inflation categories, said Thomas Simons, U.S. economist at Jefferies.

Another consequence of the pandemic was that many older workers left their jobs and were replaced by less-experienced employees, said Simons.

That, he said, was one factor that dragged on productivity—a measure of output per hours worked—and made it even harder for businesses to meet demand, pushing up prices further. It also might have driven up wages since employers were fighting over qualified workers.

But productivity has since normalized.

Many analysts also believe that the Fed’s interest-rate hikes are still working their way through the economy.

Higher rates are meant to curb inflation by making borrowing more expensive. That in turn is supposed to reduce spending by households and businesses and lead to slower wage growth, as employers cut back on hiring.

Despite a surge in the third quarter, the economy has generally expanded more slowly since the Fed started raising rates than it did before the pandemic. And growth in the current quarter is tracking lower again.

The labor market has also remained surprisingly strong, with the unemployment rate still near five-decade lows. But it has been cooling exactly how the Fed wants: Job openings are declining, and fewer people are quitting, which should help keep wage growth in check.

Quirks in how inflation is calculated could mean the figure is due for further declines.

The PCE index’s measure of housing inflation reflects what people are currently paying for a home. That figure is expected to ease since rents being advertised have been increasing at a slower rate.

When the Fed first started raising rates, there were “a lot of people saying inflation is so high that it’s impossible to get it down without a recession," said Brian Rose, senior U.S. economist at UBS Global Wealth Management. But now “it’s looking good for this soft landing scenario," he said.

The case for pessimism

Progress on inflation has been decisive enough that most investors think rate increases are over. But many say markets are underestimating how long the Fed could keep rates at current levels.

They say that the economy has cooled—but not enough.Job openings, for example, are still above prepandemic levels.

Wage growth, a critical driver of inflation, also remains elevated.

Assuming productivity grows at a typical 1% annual rate, current wage growth looks consistent with inflation of around 3% to 4%, said Andrew Hollenhorst, chief U.S. economist at Citigroup.

That could make it particularly hard to sustain declines in services inflation, which tends to be closely linked to wages. Hotel prices, for example, have declined recently but should eventually rebound, Hollenhorst said.

One factor that could keep pressuring wages is the expectation people have regarding inflation. It remains elevated by some measures, potentially driving workers to keep demanding bigger raises.

Some say investor optimism about inflation could be self-defeating.

Expectations for rate cuts have led to a sharp drop in U.S. Treasury yields, which help determine the cost of everything from mortgages to corporate debt. The rally in stocks has made it cheaper for companies to raise money and made investors wealthier, potentially spurring them to spend more.

The Goldman Sachs U.S. financial conditions index, a measure of how much overall restraint markets are imposing on the economy, has declined recently and stands below levels reached at times before the pandemic, when inflation generally wasn’t a concern.

Blerina Uruçi, chief U.S. economist at T. Rowe Price’s fixed-income division, said she is concerned about the impact of surging markets. Given the resilience of the economy, further easing in financial conditions could “provide a stimulus to demand that could reignite price pressures," she said.

Write to Sam Goldfarb at sam.goldfarb@wsj.com

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