Inflation Threat Looms as The Fed Prepares to Retain Rates
The Federal Reserve, under Chair Powell’s guidance, is signaling that interest rate cuts are unlikely in December due to ongoing inflation concerns.
Historical Context: A Reminder from the Past
Chair Powell and the Fed are viewing inflation as a significant threat, recalling a time when persistent inflation led to a dramatic 50% drop in the S&P 500 from 1972 to 1974 (see Market Crashes Compared).
The Potential Impact on the Market
The combined value of S&P 500 companies stands at approximately $45 trillion. A 50% decline in this index would erase more than $20 trillion in market value. This loss far exceeds the more than $2 trillion loss experienced during the first three days of August.
Inflation’s Disproportionate Effect on Small Businesses
Persistent inflation, aggravated by high interest rates, particularly affects smaller companies. This trend exacerbates the negative impact on the Russell 2000 small-cap index. Have you ever explored how the Trefis HQ strategy provides downside protection?
Why Inflation Remains a Challenge
Three main factors are contributing to this challenge: 1. Tariffs, 2. Deportation policies, and 3. Low tax rates. These elements create a volatile environment that complicates the Fed’s efforts to combat potential inflation spikes as we approach 2025 with the onset of the next presidential term.
Higher tariffs reduce the availability of cheaper goods in the market, leading to increased prices. Meanwhile, mass deportations of undocumented immigrants, while seemingly rational, limit cheap labor and consequently elevate service costs.
Furthermore, lowering taxes increases disposable income. Consumers may spend more, even as prices rise, which enhances their willingness to pay and feeds into inflation expectations.
What Measures Can Be Taken Against Rising Inflation?
To tackle surging inflation, the Fed is likely to resurrect its pre-2022 strategy, potentially raising interest rates above 6% and even surpassing 7% for short-term treasuries. When risk-free investments yield 6%, investors may seek higher returns from stocks.
This shift could lead to a significant migration of funds away from the S&P 500 and other riskier assets into safer investments like treasuries and savings accounts. In 2022, for example, the S&P 500 experienced a swift 20% decline, with tech giants like Nvidia losing over 50% of their value and Alphabet, Microsoft, and Meta seeing drops of 40% or more.
A Different Inflation Scenario This Time
While inflation was managed in 2022 due to temporary pandemic-related factors, this time ongoing tariffs, tax cuts, and deportations may prove a longer-lasting challenge.
The Growing Debt Dilemma
Raising concerns, JPMorgan CEO Jamie Dimon highlighted the staggering $1 trillion in annual interest payments on U.S. debt. This situation is unprecedented. Increased rates on treasury securities will only intensify interest payments. Investor confidence could quickly erode if fears of a U.S. debt default materialized during a downturn.
The Risk of Loan Defaults
This scenario also raises red flags regarding potential commercial and consumer loan defaults. Market crashes often result from individuals failing to repay their loans. Commercial real estate is already experiencing strain due to changing demand patterns after the pandemic, especially in the retail and office sectors. High refinancing rates could further destabilize this sector if interest rates rise.
Consumer loans, including personal loans, auto financing, and credit card debt, also pose significant risks to banks like JPMorgan, Citigroup, and Bank of America, which hold substantial credit card portfolios.
Looking Ahead: Leadership Decisions Affecting Policy
In challenging times, one may wonder how leaders like Trump would react if economic conditions worsen. Would he shift his stance on tariffs, taxes, and deportation?
Hopefully, his administration can guide policy changes to mitigate inflation before the U.S. faces a recession. If not, we could be looking at severe consequences, especially considering previous market crashes and their impacts on key stock performance.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
