Inflation Edges Up: Analyzing the Fed's Next Move

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week we analyze what's happening in the markets and discuss how it might affect your investments.

Well, hi, Liz Ann. Welcome back from vacation. I hope it was a good one.

LIZ ANN: It was fabulous. Went to the Greek islands for the first time in my life and absolutely beautiful and relaxing, and the market cooperated. I was able to keep up on the economic data without it being a chore. So it was a nice break. How has the middle part of your summer been?

KATHY: So far, so good, you know, not nearly as nice as that. I have to say Greece is probably my very favorite vacation spot. 

LIZ ANN: Is it? Yeah.

KATHY: I'm very jealous you got to go. But if I get lucky this year, I'll go to northern Wisconsin and look at the stars. But that's kind of one of my favorite things.

LIZ ANN: Well, that's beautiful too.

KATHY: Yeah, one of my favorite things to do. But we do have some news to talk about on the economy, mainly the inflation data, I think, in terms of the economic news. We've got just got the CPI out, the Consumer Price Index. You know, year-over-year, it's 2.7%, but the core number's up at 3%, and what I notice about it is that, you know, the trend came down from the COVID peak, the pandemic peak. It's flattened out, and now it's starting to edge back up.

And that has a lot of implications. But I think there's a lot of concerns about potential stagflation. What are you thinking about there?

LIZ ANN: Yeah, I think you're right to point out some of the details within CPI. And I think that's the mode we all should be in these days is you've got to look well past the headline, particularly of inflation reports and labor market reports, in large part due to the fact that that represents the Fed's dual mandate. So as everybody's really focused on what the Fed's next step is, I think we have to dig into the details. And I think a couple of interesting things about the CPI report. You were right to point out that core has been trending higher now. With a three handle, that's certainly not approaching the Fed's 2% territory, but also the breakdown between not just goods and services, but core goods versus core services. 

And there is still a wide gap between the two, but the rub with this latest reading is that you've seen a little bit of a hook higher in core services. The latest year-over-year reading was 3.6%, obviously, well above the Fed's target, not that they target individual components, but using that as a marker for comparison. And a lot of focus on the fact that core goods was only, "only," nobody can see me, but you see me doing air quotes, 1.2%. But that's up from –2% as recently as the second half of last year. So we had actually seen in the aftermath of that spike in inflation in 2022, which really hit the goods side of the economy because of the supply chain disruptions, that ultimately not only went into serious disinflation mode, but actually went into deflation territory. 

So that 1.2 is up from –2. So you've had more than a three-percentage-point increase in that rate of change in year-over-year terms and not something that looks to be turning around. There's also math that comes into play. So some of the categories that are very tariff impacted, there was a lot of comments about, "Hey, you know, lot of benign readings there. Maybe tariffs aren't having had much of an impact," but they did jump quite a bit in the May and June period of time. So some of it is just the comps.

We have seen some of those jumps take hold. In the aggregate, we're not seeing inflation run away, but I think if the Fed's only mandate were inflation, I don't think expectations for a cut in September would be as high as they are right now, and certainly the notion of potentially 50 basis point. What are your thoughts on some of the chatter around 50 basis points? I'm guessing you're of the view that would probably take a relatively ugly labor market report, maybe the next one, to justify 50. Would you find yourself in that camp only if you had really weak labor market data?

KATHY: Yeah, I think 50 is a high bar to cut by 50 basis points. Not that it might not be justified during the next couple of months, but with inflation going the wrong direction, that makes it really tough for the Fed to switch gears. So they've been focused on inflation because the labor market was doing well. And really, unemployment … the unemployment rate is still around 4.1%. It's not like it's shot up to 5 or 6%. You know, part of that is, though, that you have fewer people in the job market, fewer jobs, it's just kind of stagnating or stalling here. But that being said, it's going to be hard to move to shift gears that much with inflation turning higher.

As you said, the justification, the only real justification would be, boy, if the labor market was really falling apart, and that would mean that the demand side of the economy would slow down, and that would pull inflation down. They could make the argument. I think the other argument that you can make to justify a rate cut no matter what is that the Fed believes its current policy is restrictive. And so if the labor market is softening, then they can move to quote unquote "neutral," whatever neutral is, but it's probably not where the policy rate is right now. 

But 50, I think, is a high bar because it assumes that any softness in the labor market continues and worsens. And if it doesn't, which is a possibility, we've only had a couple of months' worth of data showing that it slowed down, then they're back in this conundrum of now what do we do? Inflation's turning up, labor market's OK. We don't want to be accommodative. We want to stay at neutral perhaps. Only accommodative if we really think the economy is slowing down, inflation's going to come down. So they're still in a tough place. I don't think that's changed.

LIZ ANN: Well, let me throw a "what if" at you as it relates to longer-term interest rates. So it was only a year ago that the Fed launched what at the time was the start of a loosening campaign with 50 basis points. And it was based not so much on acute labor-market weakness, but leading indicators suggesting it was coming. And that was their justification for going 50. And then of course they did two subsequent 25s. But in almost that exact span of time, when the Fed lowered the fed funds rate by a percent, the 10-year yield went up by a full percentage point. 

So my "what if" is, let's assume the next labor market report is not a huge outlier. It's sort of in line in that it shows some weakening, but not an extreme to the downside and not an extreme to the upside in a positive sense. And upcoming inflation readings are in line. So basically in line data with what we know now.

If the Fed were to cut by 50 under those circumstances, or even 25, what do you think the bond market does? What does the 10-year yield do?

KATHY: Yeah, the bond market probably would not react well at the long end of the curve. Further steepening would be my guess. And I think one of the things that we watch closely is the term premium. And that's just the extra yield you get for investing long term versus short term. And so the way it works is the market has built in its expectations for the path of the fed funds rate.

The further out you go, though, the more uncertain that is, right? It's one thing for one-year, two-year paper, you pretty well have a pretty solid view of that. And those yields will tend to track what expectations are for the Fed. Further out you go, there's more uncertainty. So there's more premium, yield premium, that you get. You should get a higher yield for that uncertainty. And we call that the term premium. It's kind of like, you know, the bucket we put everything we don't know into. 

LIZ ANN: Yeah.

KATHY: I would expect that the term premium would go up. Because there would be more uncertainty about where we're going, you'd need more compensation for potential inflation, you'd need more compensation for a potential drop in the dollar And so I think the bond market, if they went 50, might not react very well. We're actually not looking for 10-year yields to fall nearly as much in this cycle as they might have in others, simply because the inflation pressure is there, and that term premium continues to rise, due to all this policy uncertainty. And so, yeah, I think there's a risk that the market would go the wrong direction if the Fed were really aggressive here.

LIZ ANN: You know, we've touched on the labor market as it relates to Fed policy, but probably another thing we should discuss is the labor market as it relates to the Bureau of Labor Statistics. They're always in the news when you get the monthly jobs report. I don't think they've ever been in the news quite this much as they have in the last few weeks. So for anyone living under a rock, the head of the BLS, Bureau of Labor Statistics, was let go.

She'd only been in the position for a short time but was generally well regarded, and there's been a proposed new head. That person will have to go through Senate confirmation, so there's no done deal here. But it came about as a result of very significant downward revisions to the data in the most recent jobs report that we got, as you and I are recording this, a week or so ago.

One comment, and I want your thoughts on this too, Kathy. I'm not going to weigh in on whether Senate confirmation goes through or not. That's not my bailiwick. Maybe we'll ask Mike about that. But let's talk a little bit about the nature of this survey that generates the payroll numbers and maybe periods in the past where we actually have seen very large revisions. In fact, you only have to go back to the global-financial-crisis era.

We now know with the benefit of hindsight that the economy went into recession, officially starting in December of 2007. But not only at that time when you were in that moment, but well into 2008, the labor market data still looked quite healthy. The payroll numbers were positive. It was only when we got subsequent revisions, and not even just the revisions you get the subsequent month and then the month after that, but the annual benchmark revisions can often be significant. 

And we got some huge downward revisions, when all was said and done, to the data that at the time looked pretty decent in that late-2007, early-2008 period. So there is some precedent for that, especially if you're at or in a process of the economy slowing. And the same thing happens in the opposite direction when you're moving out of recession. It's also the case that the response rate has come way down, been cut about in half for the establishment survey that the BLS, Bureau of Labor Statistics, does on a monthly basis. They give basically a three-month window for companies to provide information and sometimes that information hasn't gotten in in the very beginning. Now, using that terminology of response rate, once you get to the end of that three-month period, the response rate is pretty normal, well above 90%.

So I'm just wondering whether maybe one of the manifestations of this, just due to the response rate, not nefarious behavior on the part of anyone collecting these numbers, is whether we start to pay more attention to the revisions, as opposed to sort of the reaction function being sometimes pretty wild from a market perspective based on the first read. So what are your thoughts on that just specifically, but also in general about what's going on at the BLS?

KATHY: Yeah, I think we do pay attention to revisions, right? I think that they can have a pretty big impact on the market, but we just don't get them, right? Until we get the revisions, we don't know. And I think the difficulty with the situation is we all know—people who are in the markets and who look at the data—we all know what the limitations of the data are. We know that there are problems with response rate. We know that these are just the best estimates they can make. There are seasonal adjustments that are made that have to change with time. There are benchmark revisions because they suddenly got, you know, a lot more information, and they go back, and they sa,y "Oh, by the way, four years ago, it was this," right?

LIZ ANN: There's modeling that they do, too, estimates like what they call their birth-death model. They estimate every month the birth and death of businesses. They don't always get that right, and they can get quite wrong if you're, again, if you're at one of these inflection points.

KATHY: Right, so we all know that. And I think we look at these numbers through that lens, that this is the best estimate we have at a point in time. And that we'll get more information, and we'll go from there as we get the information. A lot of us, there's a cottage industry of people who come up with their own estimates and then do their own analysis and say "No, the Bureau of Labor Statistics is off by XYZ."

So this is not news. This is a non-event in terms of the market. I think what I am concerned about, A, nobody wants to see this politicized. I don't want them to withhold information until they have more, just because this is what we use on a month-in, month-out basis to do our analysis. It's what markets rely on and have relied on for years. It's the best we've got. Not perfect, could be better. I don't see them devoting a lot of resources to making it better. So my biggest fear is that this becomes a private-sector thing. And it goes to the highest bidder. 

LIZ ANN: Yeah. 

KATHY: People, certainly, I could see hedge funds and a lot of people paying if we do away with or we postpone information from the government statistics, which are available to everybody at the same time, I could see somebody saying, "Hey, we can do this"—and there are other people who do similar things—"we can do this, but, you know, pay me."

LIZ ANN: You got to pay for it. Yeah.

KATHY: Yeah, and so then there was effectively have insiders who have a lot more and better information than we do, and we're going backwards, in terms of having more information out there. We're getting less information, having it more, you know, limited to a group of people who pay to play, and that, I think, is a risk that we all face because that loosens the integrity of price discovery when only a certain number of people have information that's valuable. So I don't know exactly how to fix all this or whatever, but I do hope that whoever comes in has the respect of the community of economists and analysts in the market and will maintain the integrity of the data.

So anyway, that's the story in the BLS and all that, and we'll probably get more information in the next month or so I would assume about how that's going to transpire, but meantime, back to the stock market. What's going on there with like earnings? I know we've got a slew of earnings that have come out over the last couple of weeks, and the market continues to march higher from what I can see.

LIZ ANN: Yeah, I think that obviously momentum is on the side of the bulls. I've often said that—it's kind of a bit of a trader lingo—but that the pain trade is probably still higher. I think positioning, at least on the part of institutions and the fact that groupings like most heavily shorted stocks have been doing well, that's suggestive of short covering. And that tends to be more on the institutional side of things. 

So that's part of why you talk about a pain trade where a change in positioning could propel the market in one direction or another, and that's probably still higher. I think earnings as a fundamental support, clearly another quarter where the bar just got set too low. And that was … you and I have talked about it on this pod, that what was interesting about what was a very strong first-quarter earnings season relative to expectations at the outset was there was no extrapolation of that strong first quarter into the remainder of the year, and that meant you had a set up for, yet again, a quarter where the beat rate was better than average, and the percent by which companies beat, and ultimately, when all was said and done, the growth rate, in this case, being about twice as high as what was expected at the start of the season. 

So I think the consensus was about 6% growth at the start of second quarter reporting season, and what they call the blended growth rate, which includes all the companies that have reported and the smattering of companies that have yet to report, is more than 13%, so that's more than a double relative to expectations. And yet again, we haven't seen much of a bump up to third- and fourth-quarter numbers. So unless things really deteriorate broadly in the economy or the earnings outlook, the set-up, yet again, could be that the bar has been set too low. So I think that's been one of more fundamental supports. 

But we have a concentration issue again. The market has become fairly narrow. The indexes are doing well, but not with ample participation. A couple examples of that to put some numbers on it. And this is data as you and I are recording this, which is midweek, so don't quote me on this maybe even two days from now at the point where we actually post this episode. But the recent all-time high hit by the Nasdaq 100 happened with less than 50% of the constituents in that index at an all-time high. You've got the two sectors of technology and communication services leading year-to-date, from a performance standpoint, but only about 60% of stocks within those two sectors are trading above their 50-day moving averages. 

So you've got this dominance again up the cap spectrum with less participation. It's the case that only less than a third of stocks in the S&P 500 have outperformed the index itself over the past month, over the past three months, over the past six months. So there is some churn and rotation happening under the surface. It's just somewhat masked by the strength of these capitalization-weighted indexes. 

And I guess the concluding message I would impart to investors about this is … I try not to say that concentration is some imminent risk for the market. It isn't necessarily. The market can be concentrated, get more concentrated, and that can last for a while. That was the case in the late 1990s. But it can represent a risk in your own portfolio if either, via chasing or absence of rebalancing, you let your own portfolio become highly concentrated. 

And that can work against you when you get even a pullback phase. In the period from mid-February, when at the time we hit an all-time high in the S&P, and then that intraday low that we all remember on April 9th, you and I were both on stage at one of our conferences when we had that just massive turnaround when the announcement was made of the delay to the reciprocal tariffs. During that near-bear-market phase, the mega-cap stocks, the Magnificent Seven, the AI theme, the tech stocks, whatever categorization you want to use, those were really hurt. They dragged down the index. So inevitably we'll get a pullback or correction. Even that doesn't seem to be near-term in the cards. And you just have to be mindful of that concentration. 

One of the overarching messages is, as an individual investor, unless you choose to make the S&P 500 the benchmark that you insist on trying to beat on a quarterly basis, you don't have to take that concentration risk. That's more of an institutional problem. If you're an institution, a fund manager, and you are benchmarked against the cap-weighted S&P on a quarterly basis, and you might get fired for underperformance, you have to be mindful of that concentration, and not having it puts you at a disadvantage from a performance standpoint. But I'll remind investors that many of those big mega-cap stocks are the largest contributors to cap-weighted index returns. They're not the best performers. 

And one way to exemplify that is, of the Magnificent Seven, none of them are in the top 10 best-performing list for the S&P 500 this year or the Nasdaq performance this year, not a single one. So they're the biggest contributors to index returns, but that's mostly due to their cap size. So you take their performance multiplied by their cap size, and that generates the contribution to return. They're not the best performers. In fact, most of the stocks that are the best performers in the Nasdaq are actually smaller-cap stocks and are not household names. So the point is that there are opportunities outside of these names, and you take a risk by concentrating when you're not necessarily going to get the performance benefit associated with it. So that's my soapbox on concentration.

KATHY: Wow, I didn't know a lot of that. Actually, that's news to me because I don't follow the stock market quite that closely. And I know there's concentration risk, and we've all heard about the handful of stocks that have been leading the market, but I did not realize that they weren't actually the high performers. So yeah, it's interesting. It's true in fixed income as well. It's always good to kind of keep rotating and make sure that you're in balance.

Right now, we're advocating that people think about adding some international for the first time in a decade because that is actually the strongest performing sub-asset class in fixed income right now, and that's largely due to the drop in the dollar, which we think will continue. But it is a good lesson to reiterate that if you're not rotating your positions on a regular basis, you can end up somewhere you don't want to be. What is it Yogi Berra said? "If you don't know where you're going, you might end up someplace else." I think that …

LIZ ANN: Yeah, I love his stuff. I think it's so brilliant. My favorite of his is "When you come to a fork in the road, take it."

KATHY: Take it. Yeah, exactly. But I always think about that one when I think about diversification. I'm like, "Yep, you know, how many times did we think we were going somewhere …"

LIZ ANN: Yep. And you know, it's happened, you know, it's on the equity side of things too, even though very recently we've seen U.S. outperformance again, but on a year-to-date basis, again, as you and I are taping this through yesterday's close, the S&P is up 9% and change on a year-to-date basis. And the MSCI EAFE index is up 19% and change. So double the performance. So you're never going to hear from us, you know, "Sell everything domestic and back up the truck and load up on only international and vice versa," but it's an easier sell. 

We had a podcast guest on not that long ago, Cameron Dawson, who had an interesting comment about international diversification on the equity side. She said, when talking about it, "We used to have to say, 'I'm sorry.' And now we get to say, 'You're welcome.'" So I thought that was a good line.

KATHY: Yeah, exactly. 

So it's the time of the week when we look ahead. What's on your radar coming up, Liz Ann?

LIZ ANN: Yeah, I'll say it again, as we're taping this, there's still some data coming out this week. Maybe most important would be the Producer Price Index in the aftermath of the Consumer Price Index. And we'll have to see if it corroborates some of what we saw in the CPI or has some additional tidbits. You sometimes get tidbits in terms of what costs are being incurred at the input level for companies. So that will keep an eye on that. And then later in the week we get retail sales. I don't have to say why that's important in terms of the health of the consumer, which is a big driver of our economy. 

We also have, coming up in the next week, import-export prices. That sometimes isn't on anybody's radar, absent being in a trade war and dealing with tariffs. We get next week, I think, it's the University of Michigan data, which is everything from consumer sentiment to inflation expectations.

Some housing data is coming out. The National Association of Home Builders, they have a housing market index, which is sort of just this big-picture proxy for the health of the housing market. And then also building permits and housing starts and housing sales, so I'll keep an eye on that. We get the Leading Economic Index, which I wouldn't fully throw that away. There are some tidbits in there, even if its … call, if you want to call it that, for a recession has not been accurate in the last couple of years, but I still think that there's valuable information that comes out of that. And I think … don't we get, do we get FOMC, the Federal Open Market Committee, meeting minutes next week, Kathy?

KATHY: Yeah, I think we do. So we should have a little bit more insight. And of course, we have all of the Fed officials speaking right now, trying to position themselves ahead of the September meeting. And we've heard a couple of them. I think it was Miki Bowman, Fed governor, saying she advocates three rate cuts this year. Christopher Waller, who dissented as well, calling for two.

So but you know, it remains to be seen. There seems to be a lot of different views right now at the Fed, and we'll have to see, you know, where they land with that.

LIZ ANN: And views being expressed outside from, I guess, people maybe having their vying for the chairmanship. I guess another couple of names were mentioned today in a Bloomberg headline, Wall Street folks, so we'll see.

KATHY: I don't know. At this point, you know, I might as well say … you know, I might as well predict you, me, and my mother, you know, will be vetted for it. 

LIZ ANN: OK. All right, so maybe we're on the list, Kathy. Who knows?

KATHY: We're throwing a lot of names out there. We'll see. I don't even venture to guess anymore. 

So that's it for us this week. Thanks for listening. You can always keep up with us in real time on social media. We both post regularly on X and LinkedIn. I'm @KathyJones—that's Kathy with a K—on both X and LinkedIn.

LIZ ANN: And I'm @LizAnnSonders on X and LinkedIn. Be wary of imposters. My public service announcement every week. You can always read all of our written reports, in addition to our social media postings, those reports have lots of charts and graphs for those that are visually inclined. And you can find that at schwab.com/learn. 

And of course, if you have enjoyed the show, we'd be so grateful if you would leave us a review on Apple Podcasts or a rating on Spotify or feedback wherever you listen. And tell a friend or tell lots of friends about the show, and we will be back again next week.

For important disclosures, see the show notes or visit schwab.com/OnInvesting, where you can also find the transcript.