[100-Year Life Finance] The Significance of the US Inflation Rate Passing Its Peak

In October, the US consumer price inflation rate was announced to be lower than expected, causing the dollar's value to plummet and stock prices to surge. However, considering the impending economic recession, the likelihood of the stock market's upward trend continuing appears low.

The October consumer price inflation rate was 7.7% compared to the same month last year, lower than the market expectation of 7.9%. The core consumer price inflation rate also fell short of expectations at 6.3%, compared to the forecast of 6.6%. This was due to falling commodity prices and a slowdown in the rising prices of food and services, which had previously driven inflation. This trend is expected to continue beyond November. It is projected that the consumer price inflation rate will drop to the mid-6% range in the first quarter of next year and reach around 3% by the fourth quarter.

First, demand is contracting. This year, the actual Gross Domestic Product (GDP) has fallen below the potential GDP. According to the recent Bloomberg consensus, the forecast for US economic growth next year is 0.4%. If this happens, the GDP gap rate?the difference between actual and potential GDP?will widen to minus 3%. Additionally, the Federal Reserve (Fed) has been rapidly raising interest rates and reducing the money supply. When the Fed raised rates, consumption decreased most significantly after about a one-year lag, and inflation also declined. On the supply side, prices of raw materials such as international crude oil, which had contributed to inflation, are stabilizing.

Considering this economic situation, the pace of the Fed's rate hikes may slow down, or the rate hike cycle may conclude soon. One of the indicators the Fed refers to when deciding the benchmark interest rate is the 'Taylor Rule.' This is a method that determines the appropriate interest rate level by referencing the difference between actual and potential GDP and the difference between actual and target inflation rates.

According to my estimates, the appropriate interest rate level has been continuously decreasing since the second quarter of this year. This is because the GDP gap rate has turned negative and inflation is falling. Historical data shows that when the appropriate interest rate level estimated by the Taylor Rule decreases, the Fed has either stopped raising rates or lowered the benchmark interest rate.

With these expectations, the dollar index fell by 3.6% over two days following the announcement of the October consumer price inflation rate. The overvalued dollar is expected to decline further. According to the real effective exchange rate of major countries published monthly by the Bank for International Settlements (BIS), the dollar was overvalued by as much as 32% in September 2022. This was the highest level since the BIS began compiling and publishing this indicator in 2000.

Stock indices also surged. In particular, the Nasdaq index, which is sensitive to interest rates, rose by 9.4% over two trading days after the inflation announcement. The question is whether this stock price rally can continue. The most important factors determining stock prices are interest rates and economic growth rates (corporate profit growth rates). As inflation decreases, market interest rates will also fall. In fact, the 10-year Treasury yield, which represents market interest rates, dropped from 4.24% at the end of October to 3.81% on November 10.

However, the decline in market interest rates signals an upcoming economic slowdown. The spread between the 10-year and 2-year Treasury yields, which serves as a leading indicator for predicting the economy, turned negative in July and has been widening recently. In November, the 3-month Treasury yield fell below the 10-year Treasury yield. This is a sign that a recession is approaching.

With consumption accounting for 70% of US GDP decreasing, there is a high possibility that the US economy will experience negative growth starting in the first quarter of next year. Since the second half of last year, household real disposable income has stagnated, yet consumption increased. As a result, the household savings rate has fallen to the low 3% range since June, the first time since the 2008 financial crisis. This means there is not much money left for consumption. As the US economy, centered on consumption, falls into recession, it is expected to deliver another shock to the stock market.

Kim Young-ik, Adjunct Professor, Graduate School of Economics, Sogang University

This content was produced with the assistance of AI translation services.