Stansberry Research

Falling Inflation Could Force the Fed's Hand

Stansberry NewsWire

Inflation growth is quickly slowing...

This morning, the U.S. Bureau of Labor Statistics released its Consumer Price Index ("CPI") data for December. The index rose 6.5% year over year ("YOY"), in line with Wall Street's expectation and lower than the prior month's 7.1% gain. On a month-over-month ("MOM") basis, the CPI fell 0.1% compared with the expectation for flat growth and a 0.1% increase in November.

This marked the sixth consecutive month where the annual CPI number has remained below its June peak. It's also the lowest YOY reading since October 2021.

Take a look...

This should give the Federal Reserve room to slow the pace of interest-rate hikes going forward. Even more, if the MOM inflation changes continue to cool, the central bank could hit the pause button on rate hikes sooner than expected...

But what exactly could this change in Fed policy look like?

Well, let's take a look at the progress made with regard to the real fed-funds rate. This rate is derived from current interest rates minus the CPI's annualized growth. Note that the "real fed-funds rate" is a bit different from the "fed-funds rate." The latter is the rate set by the Federal Open Market Committee as a guide for overnight lending rates between U.S. banks. The real fed-funds rate takes it a step further by factoring in the damage done by rising costs.

In past rate-hike cycles, the Fed has sought to keep raising interest rates until the real fed-funds rate turns positive. That's the plan this time, too.

Take a look at the numbers this year compared with past rate-hike cycles...

And now observe the progress made in 2022...

In other words, from the peak in March, when the central bank first started raising interest rates, to now, the real fed-funds rate has dropped by 6%. While it's still negative, that's a massive move.

The next question becomes when can it return to positive territory?

We modeled different projections based upon MOM inflation-growth trajectories. Prior to the pandemic, the average growth rate was 0.1%, while ever since it has been 0.4%. And since last June, the monthly rate has seen a 0.2% increase.

As a result, we think the most likely outcomes from a sustainable monthly growth rate are between 0.2% and 0.3%. Based upon our updated models, we see a positive real fed-funds rate in March of next year.

Here's what the table of 0.2% growth looks like...

And here's the model for 0.3% growth...

And more notably, this morning's lower inflation figure of 6.5% had major implications for even the most pessimistic view of inflation – 0.5% growth.

Take a look at the table showing 0.5% inflation growth...

Before the lower CPI reading was released this morning, this hyper-inflation growth scenario had the real fed-funds rate turning positive in June and only staying positive for two months. Now, it would turn positive in March and stays positive for the next eight months.

This is important as it relates to the mindset of retail and institutional investors. It tells them that the Fed is rapidly approaching its goal of a positive real fed-funds rate even in the worst-case scenario. And once that happens, it can pause rate hikes, and then even start lowering them eventually.

So, investors seeking to cash in on peak interest rates will clamor to buy assets such as U.S. Treasurys and stocks that offer high yields. In other words, they'll start to put some money to work, while also looking to buy more aggressively once they sense rate hikes are done and the Fed hasn't crashed the economy.

And because we're investing for what the economy will look like 10 to 12 months down the road, the end result will be an S&P 500 Index that's higher at the end of the year.