Opinion: Inflation reflation: Will a rate cut spark higher inflation?

Food, shelter, insurance and other needs-based prices have increased dramatically over the last year while wage growth has struggled to keep up. Forecasters are pricing in a high probability that the Federal Reserve will cut rates in September. Will a rate cut help calm prices, cushion the labor market and lead to continued economic growth? Or will it spur demand that drives inflation higher leading to a softer economy ahead?

The Bureau of Labor Statistics reported the consumer price index rose 3% for the last 12 months ending in June. However, inflation is not equal in all categories. Inflation is being felt the hardest in areas that people need the most.

Over the last 12 months, transportation services (the movement of people and products) led all other major categories by posting a 9.4% increase year-over-year. The cost for shelter increased 5.2%. Hospital services also outpaced the overall inflation rate, up 6.9%. Electricity was up 4.4% and natural gas was up 3.7%. Although food at home was up 1.1%, food away from home was up 4.1%. Meats, poultry and fish posted the largest gain in the food at home category with a 2.6% reading. Further putting the squeeze on household income was motor vehicle insurance, up a staggering 19.5%.

As an aside, the cost of coffee was up 19% from a year ago and the price for cocoa was up 160%. Tobacco products were up 8.2%, while alcoholic beverages were only up 1.8%.

The most notable detractor was gasoline coming down by 2.6%, which helped bring down the overall inflation rate to 3%. Removing volatile food and energy prices, overall core inflation came in at 3.3%.

Over the same 12-month period, average hourly wages increased by 3.9%. Although the growth in wages outpaced the overall inflation rate, needs-based items have consumed much of the growth as evidenced above. With credit card balances at near all-time highs, rising costs do not appear to be slowing down the U.S. consumer.

Debt balances have been on a steady upward trend for the last few years as pre-COVID savings have dwindled and delinquencies are ticking up. As of the close of the first quarter 2024, nearly 9% of the $1.12 trillion in credit card debt is in delinquency status. Out of the $1.62 trillion in auto loan debt, nearly 8% has transitioned into delinquency status. For reference, delinquencies are still far below the peak of 14% in credit cards and 11% in auto loans around 2010, according to the New York Fed.

The rising costs that consumers are experiencing is also being felt by employers. Unemployment ticked up to 4.3% in July from 4.1% the month prior. Property taxes, wage pressures, insurance costs, inflation on goods and services, and higher interest rates are squeezing bottom lines.

A rate cut by the Fed could cascade into lower rates for mortgages. Lower mortgage rates could spur demand in the housing market, which saw existing-home sales drop by 5.4% in June from the year prior. However, because inventory is low (down 3.1% from last June), real estate values have remained high, and the median sales price jumped to a record $426,900, according to the National Association of Realtors. Increased demand for housing stemming from lower mortgage rates could lead to inflation in housing-related items such as lumber, roofing material, paint, decor and everything that goes with buying a home.

Although these inflation statistics may seem alarming, they’re looking backwards in time. The question is what lies ahead. Perhaps the bad news has already been priced in and it’s a matter of the consumer getting used to these elevated prices and having them smooth out from here. As an example, it would be hard to fathom another 19.5% increase in auto insurance, so let’s hope that much of the bad news is behind us.

As it relates to the financial markets, interest rates on bonds have retreated recently, yet remain above the current rate of inflation. For 2024, the 10-year U.S. Treasury bond peaked at 4.7% in May. By the start of August, just a few months later, the 10-year Treasury has dipped below 4%. If inflation stays at the 3% mark or trends lower, investors who purchase bonds at higher rates could stand to maintain purchasing power by outpacing inflation with fixed income investments. As for stocks, a reduction in rates would be a welcome relief from the higher borrowing costs that may have put projects on hold or otherwise fund operations.

As for the U.S. consumer, as long as unemployment doesn’t continue its upward trend, prices stabilize from these elevated levels and wage growth keeps up, the U.S. could have a robust economy in the years ahead. However, if inflation remains persistently high and the Fed keeps rates too high for too long, the loop of higher inflation feeding higher rates could lead to hardships ahead. Work with your investment manager to make sure your portfolio will stand up to the erosion of purchasing power by inflation.

Andy Drennen is a certified financial planner and senior portfolio manager at Simmons Private Wealth in Springfield. He can be reached at andy.drennen@simmonsbank.com.