Peter Morici, professor emeritus of business at the University of Maryland, recently wrote that the U.S. economy and stock market can thrive even if inflation doesn’t fall to 2%. Here are his views.

Recent U.S. inflation data has improved, and investors are anticipating that the Federal Reserve will soon cut interest rates. Whether this is prudent, and what it means for U.S. stocks, depends on the answers to three key questions.

First, is inflation really under control? In June, the U.S. Consumer Price Index (CPI) rose 3% year-on-year, the best performance since March 2021. But this figure is still higher than the Fed's 2% target, giving the Fed enough reason to remain cautious. Food and energy prices rose 2.2% and 1% year-on-year, respectively, while prices of other goods fell 1.8% year-on-year. Service inflation remains stubborn, and housing costs rose at a year-on-year rate of 5.2%.

According to Freddie Mac, the U.S. currently has a shortage of about 3.8 million needed housing units. As cars become more complex and intelligent, repair technicians are becoming scarce. Wages in the residential construction and auto repair industries are rising at an annual rate of 9.2% and 7.2%, respectively.

An International Monetary Fund (IMF) study that analysed 100 inflation cases in 56 countries showed that when central banks ease monetary policy too early, inflation reignites, necessitating another round of rate hikes.

Second, how long can the Fed keep doing nothing and not push the economy into recession? The latest unemployment rate in the United States in June was 4.1%, higher than the 3.6% unemployment rate in June 23. Consumer spending growth has slowed, but the US economy is still creating jobs.

Eventually, the economy reaches a tipping point where unemployment rises enough to cause a decline in consumer spending and business investment. Layoffs then accelerate, jobs become scarce, and employment actually begins to shrink — all hallmarks of a severe recession.

According to the Sahm Rule, named by former Federal Reserve economist Claudia Sahm, when the three-month moving average of the U.S. unemployment rate exceeds the lowest value in the past 12 months by 0.5 percentage points, the economy is likely to be heading for a recession. Of course, this is just an observed statistical pattern, not a natural law, and it may fail this time, but now the indicator is 0.43%. If the unemployment rate rises to 4.2% in July, the Sahm indicator will reach 0.5%, and the warning signal will be "red light".

Finally, is it possible to achieve "painless" disinflation? The unemployment rate is not the best indicator of labor market tightness; it only reflects the supply of available workers.

A more meaningful statistic is the ratio of job openings (an indicator of labor demand) to the number of unemployed job seekers (an indicator of labor supply). Currently, this ratio is 1.2, roughly equivalent to the three months before March 2020, when inflation read 2.4%.

An influential study by former Fed Chairman Ben Bernanke and economist Olivier Blanchard showed that in order to anchor U.S. inflation at 2%, the ratio of job openings to unemployed people would have to fall below 1.0. That means the unemployment rate would have to be much higher — closer to 4.5% or higher.

This would break the Sam threshold, meaning that it would take a recession to get to 2% inflation, or we would have to accept inflation between 2.3% and 2.7% and a 10-year Treasury yield between 4.3% and 4.7%.

Inflation was unusually tame, well below the 2% target, from the global financial crisis to the COVID-19 pandemic. Potential easing by the Fed could create expectations of greater volatility and higher inflation over time.

In the 40 years before the financial crisis, the U.S. economy experienced inflation of 4.0% and 10-year Treasury yields averaged 7.4%. Even so, the economy and U.S. stocks prospered—the S&P 500 returned an average of 10.5% annually during that time—and that resilience should continue even if inflation remains at its current elevated levels.

The article is forwarded from: Jinshi Data