U.S. inflation news has been better lately and investors are anticipating that the U.S. Federal Reserve will cut interest rates soon. Whether that’s prudent — and what it could mean for stocks — hinges on the answers to three key questions.

1. Has inflation really been licked?

In June, the U.S. Consumer Price Index was up 3% from a year earlier — its best reading since March 2021. But that’s still above the Fed’s 2% target, and there are good reasons to be cautious. Food and energy prices were up 2.2% and 1%, respectively, while other goods were down 1.8%. Inflation in the non-energy services — 61% of the CPI — remains stubborn. The cost of shelter — 36% of the index — is rising at a 5.2% annual pace, and other services are up 5.0%.

According to Freddie Mac, the U.S. has about 3.8 million fewer housing units than needed. With more complex and computerized automobiles, repair technicians are scarce. Wages in residential construction and auto repair are rising 9.2% and 7.2% annually.

An IMF study of 100 episodes of inflation in 56 countries indicates that when a central bank eases monetary policies too soon, inflation reignites. Another round of rate increases is required and over a five-year period, total growth is less than when central bankers are more patient.

2. How much longer can the Fed hold out without tipping the economy into recession? Unemployment is 4.1%, up from 3.5% last July. Consumer spending growth has slowed, but the U.S. economy is still creating jobs.

Eventually, an economy reaches a point of inflection where joblessness rises enough to cause consumer spending and business investment to slip. Then layoffs accelerate, jobs creation becomes scarce, and employment actually shrinks — hallmarks of a tough recession.

According to the Sahm Rule, named for its author and former Fed economist Claudia Sahm, when the three-month moving average for the U.S. unemployment rate exceeds the lowest observation for that statistic over the previous 12 months by half a percentage point, the economy is likely headed for a recession. Of course that’s an observed statistical pattern, not a law of nature and could fail this time, but that statistic is now 0.43%. If unemployment rises to 4.2% in July, the Sahm Indicator hits 0.5%, it’ll be Code Red.

3. Is an immaculate deflation possible?

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 vacancies — a labor demand measure — to unemployed job seekers — a labor supply side indicator. Currently, that ratio is 1.2, about where it was for the three months prior to March 2020 when inflation was above target at 2.4%.

An influential study by former Fed Chairman Ben Bernanke and economist Olivier Blanchard indicates that to anchor U.S. inflation at 2%, the ratio of job openings to unemployed would have to fall well below 1.0. This would imply a much higher unemployment rate — closer to 4.5% or higher.

That busts through the Sahm threshold and implies getting to 2% inflation should require a recession. Or we must settle for inflation in the 2.3% to 2.7% range and the 10-year Treasury 4.3% to 4.7%.

Inflation was unusually tame between the Global Financial Crisis and COVID-19, and well below the 2% target. Fed easing now risks establishing expectations for greater future volatility and inflation ratcheting up over time.

For the 40 years prior to the financial meltdown, inflation across the entire economy was 4.0% and the 10-year Treasury yield averaged 7.4%. Still, both the economy and stocks thrived — the return on the S&P 500 averaged a 10.5% annualized return over that time, for example — and this resilience should continue even if inflation stays at this higher level.
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Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.