Inflation in the U.S. skyrocketed in the aftermath of the COVID-19 pandemic, as it did in many other countries worldwide. Disrupted supply chains, rising energy costs, and an unprecedented amount of government spending all combined to create significant inflationary pressures. By June 2022, the annual inflation rate in the U.S. peaked at 9.1%.

Understandably, policymakers, along with businesses and consumers, were alarmed. 

In response to escalating inflation, the Federal Reserve (the Fed) began an aggressive monetary tightening policy regime. They raised interest rates quickly in an effort to curb demand and rein in rising prices.

Now, with inflation, shown by the Consumer Price Index (CPI), at 2.4% as of September 2024, the Fed’s interest rate decisions (arguably) look to have been successful.

Here, we explore what that means for stock markets, and whether inflation will continue to fall.

Easing inflation

At first glance, the fall in inflation appears to be good news. The stock market has largely responded positively to the recent decline as lower inflation figures allowed the Fed to stop its rate hikes and then make a cut in September. That was a pivotal moment for the markets, as rate cuts made borrowing cheaper and corporate expansion less expensive (and more likely). This generally leads to boosted stock prices as investors see the potential for growth and higher future earnings.

Furthermore, lower inflation typically leads to improved consumer sentiment, which can also lift stock market performance. Consumers are more likely to spend when they feel more confident about the economic environment. That, in turn, helps companies’ revenues and, as a consequence, their stock prices.

All this good news could be further improved if inflation continues to decline and reaches the Fed’s 2% target. If it does, the central bank may have some wiggle room to cut interest rates further, which may lead to stronger growth as it will alleviate even more pressure on stressed households and stimulate more corporate investment – improving incomes and employment.

Stickier for longer

But if inflation remains sticky or begins to rise again, the Fed may be forced to keep rates where they are or potentially even raise them. This risks straining the economy, slowing growth, and possibly increasing unemployment.

The possibility that inflation remains higher for longer isn’t all that hard to imagine either, especially as CPI data doesn’t actually tell the full story of the American consumer. While CPI data measures the changes in the price of goods and services, it overlooks several important expenses that affect many households.

For instance, take property taxes and credit card interest payments. Neither are included in the CPI calculation, yet they affect many Americans. Currently, approximately $628 billion in credit card debt is rolled over each month, often incurring interest rates of around 22%. That’s a huge financial burden for the average U.S. consumer to bear. In fact, investors may find these debt figures prudent to consider when appraising the overall health of the economy; U.S. consumer spending accounts for around 60% of the country’s GDP.

Outlook

So, it’s important to remember that uncertainty remains. For example, while inflation has fallen, the September figures were ever so slightly higher than had been anticipated. The jobs market seems to be hard to predict, too. Sometimes, it appears to be softening, while in other months, the data released shows that despite the higher interest rate environment, employment remains strong.

Ultimately, then, while U.S. inflation has significantly improved from its 2022 highs, challenges remain. So, the impact of any inflation data on the stock market could be profound. Not only that, it is likely to be exacerbated by the volatility that has characterized markets over the last two years.

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