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Olivier Blanchard, a former chief economist at the International Monetary Fund, wrote this week that U.S. inflation is likely to fall over the next six months, but not anywhere close to the Fed’s target.Elise Amendola/The Associated Press

The economy has a habit of delivering good-news-bad-news jokes to investors. This week it offered up a doozy.

The good news? Inflation is finally edging down in the United States. The bad news? So, too, is the outlook for corporate profits.

How these conflicting forces play out is hard to predict. But with stock prices still high by historical standards, hopes of a new bull market on Wall Street seem rather far-fetched.

Investors may want to keep their enthusiasm in check. And, yes, that is despite all the good news in the consumer price inflation (CPI) data from the U.S.

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In just about every way, the CPI report this week was stellar. It showed the year-over-year rise in consumer inflation tapered to 8.5 per cent in July, down from 9.1 per cent in June.

More dramatically, it indicated that month-over-month inflation – that is, what you get when you compare July prices with June prices – was zero. That’s right: zilch. Consumer prices overall didn’t budge over the course of the month.

The report offers solid reasons to hope that the worst of the inflationary nightmare is over for the North American economy. Maybe, just maybe, inflation will fall rapidly from here.

If so, the Federal Reserve and the Bank of Canada won’t have to be quite so militant about raising interest rates to crush the economy and restrain demand. Recession may be averted.

But investors should be careful what they wish for. Soaring inflation in 2021 was accompanied by surging stock prices. It’s entirely possible that fading inflation in 2022 will go hand in hand with falling stock prices.

Inflation and stocks

The S&P 500 boomed last year as inflation soared. The question now is whether stocks can continue to rise as inflation begins to taper.

S&P 500 Index

U.S. CPI, YOY % change

9.0%

4,800

7.5

4,600

6.0

4,400

4.5

4,200

4,000

3.0

3,800

1.5

3,600

0.0

March

May

July

Sept.

Nov.

2021

the globe and mail, source: federal reserve bank of st. louis

Inflation and stocks

The S&P 500 boomed last year as inflation soared. The question now is whether stocks can continue to rise as inflation begins to taper.

S&P 500 Index

U.S. CPI, YOY % change

9.0%

4,800

7.5

4,600

6.0

4,400

4.5

4,200

4,000

3.0

3,800

1.5

3,600

0.0

March

May

July

Sept.

Nov.

2021

the globe and mail, source: federal reserve bank of st. louis

Inflation and stocks

The S&P 500 boomed last year as inflation soared. The question now is whether stocks can continue to rise as inflation begins to taper.

S&P 500 Index

U.S. CPI, YOY % change

9.0%

4,800

7.5

4,600

6.0

4,400

4.5

4,200

4,000

3.0

3,800

1.5

3,600

0.0

March

May

July

Sept.

Nov.

2021

the globe and mail, source: federal reserve bank of st. louis

At the very least, recent history trashes the notion that rising inflation is necessarily bad for stocks. Over the course of 2021, annual CPI inflation in the U.S. rocketed from under 2 per cent to more than 7 per cent. During that time, the S&P 500 gained more than 25 per cent.

It wasn’t that rising inflation directly helped stock prices. It was more a matter that both of them were getting a lift from the same underlying force – surging demand. Corporate profits and inflation jumped higher in tandem as cash-rich consumers spent freely and Washington poured money into supporting the pandemic-stricken U.S. economy.

Now the same gears are whirring in reverse. Washington is slashing its spending. Consumer spending is still growing but at much more restrained levels. Meanwhile, wages are rising as workers scramble to make up the buying power they lost over the past year to inflation’s bite.

It would be no surprise if corporate profits struggle in this harsher environment. If so, U.S. stocks face a headwind.

Similarly, analysts at Capital Economics see the S&P 500 index of large U.S. stocks finishing the year at 3,600, down considerably from its current level around 4,200. They argue that corporate profits are vulnerable. Outside of the energy sector, expectations for earnings have been falling steadily.

Beyond earnings, there is the big question of just how much to trust any one month’s CPI numbers. The fall in inflation during July largely reflected falling oil and gasoline prices and a few other factors. Even in the best case where those trends don’t reverse, there is still reason for concern.

“The latest data would appear to be consistent with the idea that underlying inflation has accelerated from around 2 per cent a year to around 5 per cent a year,” Matthew Klein of The Overshoot economics newsletter concluded.

It is not clear how the Federal Reserve will respond to this. Five-per-cent inflation is still far above the central bank’s 2-per-cent target.

If inflation does fall in coming months but remains stuck at 5 per cent – or even 4 per cent or 3 per cent – the Fed will be faced with tough decisions, especially if the economy is simultaneously slowing.

Policy makers may be forced to choose between keeping interest rates high to squeeze out an excess percentage point or two of inflation, or cutting rates to support a weakening economy. Neither option would be ideal.

One scenario would result in guiding inflation back to the 2-per-cent target but perhaps at the cost of a painful recession. The other might avert a recession but leave inflation above target.

Olivier Blanchard, a former chief economist at the International Monetary Fund, wrote this week that U.S. inflation is likely to fall over the next six months, but not anywhere close to the Fed’s target. He sees inflation ratcheting down to about 3 per cent next year, at which point, “the Fed may decide to state mission accomplished, and stay at 3 per cent, if not forever, at least for a while.”

The only problem with this position is that it would mean considerable uncertainty for investors, who might rightfully be confused about whether inflation targets still matter. If 3-per-cent inflation is acceptable, why not 4 per cent? There is still plenty of potential for mayhem ahead.

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