Whether the Federal Reserve cuts interest rates or not, inflation and US stocks will rise

University of Maryland's distinguished business professor Peter Morici recently pointed out that even if inflation does not drop to 2%, the U.S. economy and stock market can still thrive. Here are his views.

Recent inflation data in the U.S. has shown improvement, and investors are expecting the Fed to cut interest rates soon. Whether this approach is prudent, and what it means for U.S. stocks, depends on answers to three key questions.

First, is inflation really under control? In June, the U.S. Consumer Price Index (CPI) increased by 3% year-on-year, the best performance since March 2021. However, this number is still above the Fed's 2% target, giving the Fed enough reason to remain cautious. Food and energy prices rose by 2.2% and 1% respectively year-on-year, while prices of other goods fell by 1.8% year-on-year. Service sector inflation remains stubborn, with housing costs rising at a rate of 5.2% year-on-year.

According to Freddie Mac's data, the U.S. currently lacks about 3.8 million needed housing units. As cars become more complex and intelligent, repair technicians are becoming scarce. Wages in the residential construction and automotive repair industries are rising at rates of 9.2% and 7.2% per year respectively.

An IMF study analyzed 100 cases of inflation in 56 countries, showing that when central banks ease monetary policy too early, inflation can reignite, requiring another round of rate hikes.

Second, how long can the Fed's stance of not pushing the economy into recession be maintained? The latest U.S. unemployment rate data for June was 4.1%, higher than the 3.6% unemployment rate in June 23 years ago. Consumer spending growth has slowed down, but the U.S. economy is still creating jobs.

Finally, the economy will reach a turning point, with the unemployment rate rising to a level that leads to a decline in consumer spending and business investment. Subsequent layoffs accelerate, job opportunities become scarce, and employment actually begins to shrink - all signs of a severe recession.

According to the Sahm Rule named after former Fed economist Claudia Sahm, when the U.S. unemployment rate's three-month moving average exceeds the lowest value in the past 12 months by 0.5 percentage points, the economy is likely heading towards a recession. Of course, this is just an observed statistical pattern and not a natural law, so it may fail this time, but the indicator is currently at 0.43%. If the July unemployment rate rises to 4.2%, the Sahm indicator will reach 0.5%, signaling a "red light."

Lastly, is achieving "painless" disinflation possible? The unemployment rate is not the best indicator of labor market tightness; it only reflects the supply of available workers.

A more meaningful statistic is the ratio of job vacancies (labor demand indicator) to unemployed job seekers (labor supply indicator). Currently, this ratio is 1.2, roughly equivalent to the three months before March 2020, when the inflation reading was 2.4% Former Federal Reserve Chairman Bernanke and economist Olivier Blanchard's influential study shows that in order to anchor US inflation at 2%, the ratio of job vacancies to unemployed individuals must drop below 1.0. This means that the unemployment rate will have to be higher - close to 4.5% or higher.

This would break the SAM threshold, meaning that achieving a 2% inflation rate would require a recession, or we would have to accept an inflation rate between 2.3% and 2.7%, as well as a 10-year US Treasury yield between 4.3% and 4.7%.

From the global financial crisis to the COVID-19 pandemic, inflation has been unusually mild, well below the 2% target. The Fed's potential accommodative policies may lead to expectations of increased future volatility and rising inflation over time.

In the 40 years before the financial crisis, the inflation rate of the US economy was 4.0%, and the average yield on 10-year US Treasury bonds was 7.4%. Nevertheless, both the economy and US stocks prospered - the S&P 500 index had an average annual return of 10.5% during this period. Even if inflation remains at its current higher levels, this resilience should continue.