Key takeaways

  1. June’s Consumer Price Index (CPI) was higher than expected, which probably means the Fed is going to stay aggressive in fighting inflation
  2. The Fed will eventually tame inflation, the question is whether they will cause a recession in the process
  3. After a difficult start to 2022, we believe bonds will perform well as a recession hedge going forward
  4. Generally, stocks produce above-average returns in the immediate aftermath of a bear market, so now is a good time to stay in the market

On Wednesday, July 13, the Department of Labor released the Consumer Price Index (CPI), a widely followed measure of inflation. Unfortunately, the report showed that inflation is not only still high, but was even higher than expected in the month of June. What does that mean for financial markets and your investments? And what can we glean about inflation looking forward? Here are our thoughts on all of these issues.

What was in the CPI report?

Unfortunately, there were no caveats or silver linings in the CPI report. Inflation is running very hot no matter how you look at it. The main headline is that overall, consumer prices have risen by 9.1% over the past year, which is a shocking number in and of itself. Additionally, markets were caught by surprise because the rest of the CPI report showed that price increases were quite broad. Even excluding food and energy, consumer prices rose by 0.7% in June, which would translate to an 8.3% annual pace. Looking into the individual categories, there was no one or two that were driving this increase. Prices are rising everywhere you look.

What does this mean for the Fed?

The Fed is absolutely committed to bringing inflation back down to their 2% target. Several times in recent public appearances, Fed Chair, Jerome Powell, has said that their commitment to fighting inflation is “unconditional” and they would do whatever it took, even if it meant that unemployment rose. 

At the Fed’s June meeting, that unconditional commitment translated into the Fed raising their target on short-term interest rates by 0.75%, something they hadn’t done since 1994. The Fed uses interest rate increases to control inflation because higher rates tend to dampen spending. If there is less total spending in the economy, it should mean that prices won’t rise as aggressively, and thus inflation should slow. More on this in a moment.

Leading up to this CPI report, there was some question as to whether the Fed would hike by another 0.75% or downshift to 0.50% when they meet on July 27. Today’s CPI report almost certainly means a 0.75% hike, and there is talk among market participants that the Fed could consider hiking a full 1%. The same day of the CPI report, the Bank of Canada did exactly that and raised their rate target by 1%, so perhaps it isn’t as far-fetched as it may initially seem. 

What will cause inflation to finally slow down?

Inflation is fundamentally a mismatch between supply and demand. In effect, consumers have both the money and the desire to buy more goods and services than the economy can produce. All that money chasing a limited amount of goods and services results in prices going up.

As we mentioned above, the Fed is trying to curb inflation by raising interest rates. It is somewhat complicated how this works, but the most basic effect has to do with credit. Essentially as interest rates rise, it becomes more expensive to buy anything on credit. That includes everything from individuals buying a house to companies building a new factory. Presumably, if it is more expensive to borrow, people will do it less. And that means there are fewer buyers for the kinds of things that require credit. In turn, if there are fewer buyers, the price should decline, all else being equal. Finally, if there are fewer buyers of these big ticket items, it may also mean less demand for other items. For example, if housing demand declines, the demand for furniture will probably drop as well. Higher interest rates start a sequence of effects that should help reduce the pace of price increases.

The tricky thing is that we don’t know how high interest rates need to get to set this sequence off, or for that matter, how much demand needs to subside before inflation gets back under control. The only thing the Fed can do is raise interest rates and see if demand slows. If not, they raise rates again, and so on. 

The difficulty is that the economy doesn’t react to hikes in real time. For example, even if higher interest rates slow the demand for new homes, it takes months to build a new home, and likely all the projects currently under construction will get completed. First, the construction was probably funded via a loan at the beginning of the project when rates were lower. Second, it is usually in the builder’s best interest to finish any construction already underway instead of scrapping partially completed projects. That means all of the materials will get purchased, the construction workers will get paid, etc. Today’s rate hikes don’t really affect activity today, it affects activity in the future.

Looking forward, inflation isn’t the risk, recession is

Since the Fed doesn’t know exactly how much spending needs to decrease in order to slow inflation, nor how high interest rates need to get to slow spending, they also don’t know when they’ve hiked by too much. Therein lies the risk for financial markets and the economy: if the Fed unknowingly hikes rates by too much, that solves the inflation problem, but it also pushes the economy into a recession.

Our view is that given the Fed’s strong commitment to fighting inflation, they will eventually succeed and inflation will return to something close to 2%. What is much less clear is whether or not the Fed will damage the economy in the process.

This leads us to a few conclusions. First, we are often asked about various assets as a “hedge” against inflation. Most of those assets will only work if the Fed fails in its mission to restore price stability, and that is not a bet we would make. This is because even with inflation continuing to move higher, most of the “inflation hedge” assets have performed poorly recently. Assets like gold, Treasury Inflation-Protected Securities (TIPS), oil, crypto, Real Estate Investment Trusts (REITs), and industrial metals have all lost money since March. This is a sign that the market understands that more inflation means more Fed rate hikes, not that inflation will last longer.

Second, we have presented our case as to why now is probably a good time to own bonds. Bonds have been a poor mitigator of risk so far in 2022, but we believe they will work well as a recession hedge going forward. 

Lastly, recessions do indeed tend to be tough periods for stocks, but in today’s circumstances that is less clear. Stocks are already down more than 20% year-to-date, and there is a good case that if there is a recession, it could be a mild one. That may mean that any weakness in company profits is already reflected in prices. We have written more detailed thoughts on recession risk in Is a Recession on the Horizon? and have some advice on dealing with down markets in Investing in Down Markets.

Overall, markets are always forward looking, meaning that today’s price of a stock or bond is set by expectations for the future. This is what people mean when they say some event is “priced in” to markets. Today, high inflation is priced in. That there is a risk of recession is also priced in. You can’t make money in markets betting on things that everyone already knows. Usually, relatively strong returns for markets follow periods of weak returns. Rather than letting inflation or recession fears scare you out of the market, we believe now is a great time to be invested.

A CFP® Professional with Facet can help you create an investment strategy, and develop an ongoing plan to make sure your money is working hard for you.