Fall in Inflation has a Downside…

The inflation rate in the United States continues to slow down, as revealed by the Consumer Price Index (CPI). This trend has significant implications for the stock market and investors. In this article, we will explore the effects of this inflation decline and discuss its potential impact on investments.


Fall in inflation may not be good for stocks

Inflation in the United States continued to decelerate in April, according to the Consumer Price Index (CPI), marking its tenth consecutive decline and falling slightly more than expected by market analysts.

The overall CPI rate, known as “total CPI,” stood at 4.9% on an annual basis, marking its first drop below 5% in two years. The measure of “core” CPI, which excludes volatile energy and food prices, reached 5.5%. On a monthly basis, both the “core” and “total” measures recorded an increase of 0.4%, indicating that prices are still rising but at a slower pace.

However, there is positive news in the report: “supercore” inflation—the preferred measure by the Federal Reserve (Fed), which tracks essential services by excluding housing prices and therefore better reflects pressures in the labor market—also decelerated to 5.1%, compared to the previous 5.8%.


What does this mean?

This suggests that investors may be optimistic. With inflation now consistently declining, it is likely that the Federal Reserve (Fed) will temporarily suspend interest rate hikes. If inflation had remained stable in April (or even increased), investors would have had to reconsider their expectations of rate cuts later this year, which would result in a significant drop in bond and stock markets. Fortunately, that did not happen.

However, it’s not all good news. Inflation is still uncomfortably high for the Fed to completely change its stance and start reducing rates. It will likely require further economic challenges for inflation to decisively fall towards the Fed’s long-term target of 2%. While the total CPI has dropped from a peak of 9.1% in June to just 4.9% in April, the “core” inflation indicator remains persistently close to the peak of 6.6% observed in September. Achieving further reductions will be more challenging with falling oil prices and the recovery of supply chains already reflected in this measure.

Furthermore, this inflation report shows that many components are still rising, indicating that a more significant slowdown in wage growth will be necessary for goods and services inflation to return to more normal levels. In fact, a simple analysis of month-to-month price gains in recent months reveals that inflation still does not show encouraging signs of decline.

Therefore, a pause in interest rate hikes is likely, but don’t expect a rate cut from the Fed unless there is a more significant economic slowdown. Bond investors are awaiting this combination of rate cuts and economic deceleration, just like myself, but this expectation is not shared by stock investors.

Although inflation has decreased more rapidly than growth, it is understandable that the market reacts positively. However, it is when growth starts to decline more rapidly than inflation that things can become complicated. While the current report indicates that the ideal scenario of a “soft landing,” where interest rate hikes stabilize the economy enough to bring inflation back to target without triggering a recession, is somewhat more likely, I wouldn’t bet all my chips on it just yet. In this environment, it is advisable to follow the familiar strategy: hold a portion in gold, some Treasury bonds, and a cash reserve to strengthen your portfolio in case things don’t unfold as planned.


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