Is Wall Street Getting Fooled by a CPI Head Fake?

Thursday’s enormous market runup assumes that inflation is on a downtrend. What if that isn’t so?

Word that the Consumer Price Index’s slide to a 7.7% annual pace in October, a much steeper decrease than expected, triggered a blowout market rally Thursday. The S&P 500 jumped by more than 5.5%.

Well, the wonderful world of economic statistics, like stocks indexes, seldom moves in a straight line. “We have been here before, however, with inflation showing signs of slowing in July only to” disappoint later, wrote Josh Jamner, investment strategy analyst at ClearBridge Investments, in a research note.

He has a point. The CPI climbed to an annual 9.1% in June, its highest point in years. Then in July it tumbled to 8.5%. Investors took heart, amid talk that the Fed would ease up. CPI reductions in the next two months were small and unimpressive, though.

The market’s apparent take away Thursday was that inflation will continue to fall, and thus, in the near future, the Federal Reserve will relent on its hawkish campaign to drive down inflation via punishing interest rate hikes—either by halting its increases or pivoting, lowering rates to offset economic problems.

But Jamner observed that the central bank has given no indication it will desist any time soon: “The upshot: it will likely take further slowing in inflation in the coming months for the Fed to feel fully confident in putting the brakes on future rate hikes.”

Beyond all this is the Fed’s record of pushing down inflation using the blunt instrument of boosting rates. Contrary to the oft-told tale about how Paul Volcker, as Fed chief, tamed double-digit inflation four decades ago with single-minded tightening, history shows he wasn’t that undeviating. He did a couple of pivots, as described in a study by economist Alan Reynolds: once in 1980, to combat a recession then, and again in 1981 and 1982 to help the economy in an even worse downturn.

Despite the Volcker’s inconsistent moves, inflation continued to descend back then. How come? The Volcker Fed’s early high rates and the twin recessions changed Americans’ psychology, which had resigned itself to inflation as a part of life.

As for investors’ reactions Thursday, it could be chalked up to irrational exuberance. That was a phrase coined by Alan Greenspan, in 1996 when he was Fed chair, in reference to that market euphoria of the time. Ironically, he also invented the “Greenspan put,” using Fed actions to halt excessive stock declines. Thus far, today’s Fed doesn’t seem inclined to reprise the Greenspan put.