Over the last month and a half, stock markets have been spurred by mounting evidence of "peak inflation." The S&P 500 has gained just shy of 14% from the mid-October low and now sits a hair below where past runups have stalled. Market participants have been connecting a peak in the rate of inflation to a slowdown in the pace of Fed Funds rate hikes, a sentiment largely confirmed by Federal Reserve Chairman Jerome Powell early in the week but with a word of caution. Where the Fed Funds rate ultimately ends up is more important than the pace at which it gets there. Without a persistent decline in inflation, the expected endpoint for interest rate hikes will continue to drift higher and make it challenging for stock prices to rise. For the time being, stock prices hinge on every word about inflation.

Putting aside volatile food and energy prices, the path of inflation will be determined by three critical components: core goods, shelter costs, and core services. Increases in core goods prices have been easing for the last several months with supply chains correcting. Many retailers are now overstocked and marking down their inventories heading into the holiday season. Absent any further disruptions to supply chains, economists, expect core goods prices may begin to fall. While this is good news, it is only part of the story.

Shelter costs remain red hot across inflation measures. However, there is a well-established lag between surveys and actual market rents. More timely data suggests that the weakness in the housing market is starting to cool the pace of rent increases dramatically. Economists expect that inflation surveys will catch up to the reality on the ground over the next few months. Still, rising wages are likely to keep a floor under rents to some degree. Shelter cost inflation is expected to ease but not reverse entirely.

Core services are the biggest wild card for the Federal Reserve. It is the largest of the inflation categories and the most directly impacted by wage pressures. Despite 3.75% of total Federal Funds rate hikes to date, the labor market has hardly given an inch. The U.S. economy added 63,000 more jobs than expected in November, and there are still 1.7 job openings for every unemployed person. This exceptionally tight labor market continues to yield wage gains over expectations, largely as a result of challenging demographics. For November, wages increased 5.1% year-over-year vs. expectations of 4.6%. Wage increases at this level are unsustainable and will ultimately be passed on to the consumers in the form of higher prices. Service businesses are particularly exposed as labor makes up a more significant share of total costs.

On balance, there is still enough inflation pressure in the pipeline for the Fed to keep its foot firmly on the brake. Even with functioning supply chains and a cooling housing market, structural forces make the task of bringing down inflation difficult. The higher the Fed Funds rate needed to beat inflation, the higher the probability of economic pain. With that backdrop, quality companies with strong balance sheets continue to earn a premium.

Preston May, CBE®
Research Analyst

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S&P 500: Standard & Poor’s (S&P) 500 Index. The S&P 500 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries.