The Fed’s Inflation Dilemma — and What It Means for the US Share market

Why hasn’t the US Federal Reserve raised interest rates?

One of the more difficult questions facing investors today is why the US Federal Reserve has not increased interest rates when inflation remains above its 2% target.

The answer is that monetary policy is not simply about inflation. The Federal Reserve has a dual mandate: maintaining price stability while also supporting maximum employment. Today, the Fed is trying to balance two competing risks - inflation that remains too high and an economy and labour market that are showing signs of losing momentum.

The Fed has left its policy rate unchanged at 3.75% and continues to describe inflation as elevated. However, recent data have provided some reassurance. July producer prices were unchanged for the month, while the annual rate slowed to 4.7% from 5.5% in June. Recent consumer inflation data have also been relatively benign.

This gives the Fed an important reason to wait.

The problem is that inflation is still not where the Fed wants it

The Fed's formal inflation objective remains 2%. Inflation above that level for an extended period creates a difficult policy choice.

If the Fed raises rates too aggressively, it risks slowing economic growth, weakening employment and potentially causing unnecessary damage to the economy.

If it waits too long and inflation proves persistent, it risks allowing inflation expectations to become embedded. That could ultimately require a much more aggressive tightening cycle later.

This is why the Fed appears reluctant to make a small rate increase simply because inflation is above target. It wants to determine whether current inflation is persistent or whether it will continue to moderate without further tightening.

There is also an important distinction between inflation being high and inflation accelerating.

If inflation is 3% but falling, the policy response can be very different from inflation at 3% and rising.

For now, the Fed appears to be betting that inflation will gradually moderate.

Why should investors care?

Because the US share market is being valued on the assumption that interest rates will not move materially higher.

This matters particularly for the growth and technology companies that have driven much of the market's performance.

The valuation of a company is ultimately based on the present value of its future cash flows. As interest rates rise, those future earnings become worthless today.

The effect is greatest on companies where investors are paying high prices for earnings expected many years into the future.

This is one reason higher interest rates can be particularly uncomfortable for high-growth technology companies.

It does not necessarily mean their businesses become worse.

It means the price investors are prepared to pay for those businesses can fall.

The bigger risk may be the surprise

The most important issue for markets may not be whether the Fed raises rates.

It is whether investors are forced to change their expectations about where interest rates are heading.

Markets have become accustomed to the idea that inflation will continue to moderate and that the next meaningful move in US rates will eventually be lower.

If inflation instead proves sticky, the Fed could be forced to increase rates.

That would create a very different environment for equities.

The S&P 500 has recently reached record highs, while the Nasdaq has also continued to perform strongly.

At these levels, the market has relatively little room for disappointment.

A 0.25% rate increase in isolation does not sound dramatic.

But if it signals that inflation is proving more persistent than expected, the impact could be much larger than the rate increase itself.

What could happen to US shares?

There are three potential outcomes.

1. Inflation continues to fall

This is the most favourable outcome for markets.

The Fed can remain on hold or eventually reduce rates. Economic growth remains reasonable and corporate earnings continue to grow.

In this scenario, higher-quality growth companies can continue to perform well.

2. Inflation remains stubborn, but rates stay unchanged

This is potentially more complicated.

The Fed may tolerate inflation above target because it is concerned about weakening growth and employment.

Markets could remain supported, but valuations may become increasingly difficult to justify if bond yields remain elevated.

This is the environment where we would expect greater differentiation between companies with genuine earnings growth and those relying primarily on investor enthusiasm.

3. Inflation reaccelerates and the Fed has to raise rates

This is the scenario we believe investors should be most conscious of.

A rate increase would raise the discount rate applied to future corporate earnings, increase financing costs and potentially reduce economic demand.

The effect would likely be greatest in the most highly valued areas of the market.

Importantly, this does not mean the entire share market would necessarily fall by the same amount.

Companies with strong balance sheets, reliable cash flows, pricing power and reasonable valuations may prove much more resilient than highly valued companies whose investment case depends on very strong growth continuing for many years.

Summary 

We don't believe the current situation calls for abandoning US equities.

However, it does reinforce the importance of valuation and diversification.

The US market has delivered extraordinary returns over the past decade, but investors should be careful not to confuse strong companies with attractive share prices.

The underlying businesses can continue to perform exceptionally well while their shares become less attractive if investors are paying too much for future growth.

This is particularly relevant in an environment where inflation remains above the Fed's target and the path of interest rates is uncertain.

Our focus therefore remains on managing the balance between quality, valuation and growth, rather than simply trying to predict the next move in interest rates.

It is to recognise that when valuations are elevated, the market becomes increasingly sensitive to changes in interest rates and expectations.

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