Low Inflation Fueling Rally But Stocks Could Fall 20.16% In The Next Year

We don’t think inflation is focused on enough when reviewing where the business cycle is headed. When inflation is high, the Fed needs to raise rates which slows economic growth. The Fed was left with ample room to dovishly react to the economic slowdown late last year because inflation has been modest even though this expansion is almost the longest since the 1800s and wage growth is rising.

The Fed’s dovish policy shift was supported by the January CPI report. Headline monthly inflation was flat which matched December and was below estimates for 0.1%. Year over year CPI was 1.6% which beat estimates by 0.1% but fell from 2% in December. As the chart below shows, this is the lowest year over year change since September 2016. This latest decline was caused by oil price correction. 

When oil prices fall, core inflation is higher than headline inflation. This volatility in headline inflation explains why the Fed uses core inflation to set policy. Monthly core CPI was 0.2% which met estimates and was the same as last month. When you round yearly core CPI up, it was 2.2% which beat estimates by 0.1% and was the same as December. However, when you don’t round the metrics, core CPI was 2.148% in January and 2.214% in December. January is almost a full tenth lower than December.

This was the lowest core inflation reading since April 2018. The 2-year stack was almost exactly the same sequentially as it was 3.98% in both months, rounded to the nearest hundredths place. The big test will be in March as last year core inflation rose 27 basis points to 2.1%. If the 2-year stack stays the same, then core inflation will likely fall below the Fed’s target, which supports the Fed’s dovish turn. Core inflation should be similar or fall since there is a global economic slowdown.

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