The Consumer Price Index (CPI) tracks the change in price of a basket of goods and services over a given period of time. It's the primary measure of inflation, and the U.S. Federal Reserve aims to keep the index growing by around 2% each year.
The Fed will adjust the federal funds rate -- the nation's benchmark interest rate -- if inflation swings too far above or below its target, which can directly affect consumer spending, corporate profits, and the prices of assets like stocks, bonds, and real estate.
The CPI soared to a 40-year high in 2022, which prompted the Fed to aggressively hike interest rates. It appears to be working, because inflation cooled significantly in 2023, and it continues to trend lower this year.
The last time the CPI fell so quickly was during 2009, and on that occasion, it sparked one of the longest bull markets for the S&P 500(SNPINDEX: ^GSPC) in stock market history. Here's why it could happen again.
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Here's what typically drives inflation
A number of factors can trigger the supply/demand imbalances that drive inflation higher, including:
- Low interest rates and a sudden increase in money supply (otherwise known as loose monetary policy).
- High government spending -- especially when it includes cash payments, which travel through the economy very quickly.
- Supply chain shocks that lead to a higher cost of production, which is passed on to consumers in the form of price increases.
It just so happens that all three points were in play during the worst of the COVID-19 pandemic in 2020 and 2021.
During that period, the Fed cut the federal funds rate to a historic low of 0.25% and simultaneously injected trillions of dollars into the financial system through quantitative easing (QE). U.S. government spending also surged, which included stimulus checks for most consumers. Finally, global manufacturing hubs periodically shut down to prevent the spread of the virus.
That inflationary cocktail caused an 8% year-over-year jump in the CPI in 2022, which was the largest annual increase since 1981.
Inflation has cooled significantly
During the 18-month period between March 2022 and August 2023, the Fed raised the federal funds rate from its historic low of 0.25% all the way to 5.50%, where it remains today. The goal was to cool inflation by counteracting some of the stimulus raging through the economy.
However, higher interest rates can increase the cost of capital and slow consumer spending, both of which dent corporate profits. As a result, the S&P 500 index plunged into a bear market in 2022 as investors favored safer assets like U.S. government Treasury bonds instead.
Fortunately, higher rates did cool the CPI to a more manageable 4.1% in 2023. It continues to trend toward the Fed's 2% target, with the most recent annualized CPI reading (April 2024) coming in at 3.4%.
As a result, the Fed doesn't plan to raise interest rates any further. In fact, the CME Group's FedWatch tool predicts that there could be at least one cut by the end of 2024.
The S&P 500 rebounded in 2023 with a 26.3% gain, and it's up roughly 12% this year, in lockstep with the decline in inflation and the potential for imminent rate cuts.
2009 and 1982 offer clues as to what happens next
The CPI fell 3.9 percentage points between 2022 and 2023 (from 8% to 4.1%). That was the steepest drop since 2009, and since 1982 before that. While each instance stemmed from a unique set of circumstances, investors often react in a predictable manner to changes in inflation and interest rates.
The CPI started ticking higher in 2002 on the back of excessive consumer borrowing which fueled a housing bubble. The Fed tried to tame the situation by increasing rates from 2004 to 2006, and the CPI eventually peaked at 3.8% in 2008. Higher rates, combined with the bursting of the housing bubble, sent the S&P 500 crashing 37% that year.
In 2009, the CPI fell to negative 0.4% (signaling deflation), marking a decline of 4.2 percentage points from 2008. The Fed started slashing rates in 2008 to counteract the financial crisis, so the federal funds rate spent all of 2009 at a rock-bottom level of 0.25%.
Despite a collapsing economy and mountains of uncertainty, the S&P 500 still rebounded with a 26.5% gain in 2009. Investors can't earn a return on their cash when interest rates are near zero, which pushes them into growth assets like stocks.
The early 1980s produced a similar outcome. The CPI peaked at 13.5% in 1980 and had declined to 6.1% by 1982, thanks to aggressive rate hikes by the Fed. That slowdown in inflation -- and subsequent interest rate cuts -- triggered a 21.5% gain in the S&P 500 in 1982, erasing its losses from the prior year.
The S&P 500 just entered a new bull market, and it could last several years
As I mentioned earlier, the S&P 500 jumped 26.3% in 2023, and it's up almost 12% this year at recent levels. It actually set a new all-time high in January, cementing the bull market that technically began when the index bottomed in October 2022.
That means the new bull market is technically around 19 months old, but history suggests it could last several years. For example, 2009 was the beginning of a nine-year bull run which was tied for the longest in history. Similarly, 1982 sparked an eight-year winning streak.
That implies that the S&P 500 could remain in bull territory until 2031! However, three things will need to happen to sustain its momentum: The CPI must continue to trend lower and settle near 2%, interest rates will have to come down (or at least stop rising), and American companies need to continue growing their earnings.
All three things appear to be happening right now, so investors will probably enjoy more gains in the stock market from here.
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Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool recommends CME Group. The Motley Fool has a disclosure policy.
