Inflation Poses Little Threat to the Stock Market

Last week, we kicked off a broad review of the key macro forces shaping the stock market, focusing on the health of the economy and earnings expectations. The takeaway was clear: the economy appears to be in solid shape, and consensus forecasts for earnings growth this year are not just positive, but notably strong.

Admittedly, there has been no shortage of headlines and market volatility since then. It would be reasonable to dive into geopolitical developments, market breadth, or the current state of the AI trade. However, at least for now, none of these factors have altered the market’s primary trend. With that in mind, it makes sense to continue our top-down assessment of the major macro drivers.

Having already examined the economy and earnings, the remaining areas to address are inflation, Federal Reserve policy and interest rates, and market valuations. Let’s turn to those next.

What Is Inflation?

The Federal Reserve defines inflation as a sustained rise in the prices of goods and services over time, reflecting a general increase in the overall price level across the economy. Similarly, Investopedia and standard economics textbooks describe inflation as a gradual erosion of purchasing power, manifested through a broad-based increase in the prices of goods and services over time. The International Monetary Fund frames inflation as the pace at which prices rise over a given period, indicating how much more costly a representative basket of goods and services has become.

Or, as I was taught in my very first economics class many years ago, inflation can be summed up as “too much money chasing too few goods.”

In Focus

There is little doubt that inflation has dominated the attention of the Federal Reserve, policymakers, consumers, and financial markets for several years. Unless one has been completely disconnected from events, it is well known that inflation surged in the aftermath of the COVID crisis, driven by trillions of dollars in government stimulus flowing into household bank accounts and severe disruptions across global supply chains.

This surge fueled fears that the United States was heading back toward the inflationary turmoil of the 1970s—a period the Fed ultimately subdued, but only at significant cost to the economy. With the Consumer Price Index approaching double-digit territory in early 2022, such concerns were understandable.

As the pandemic faded and supply chains normalized, inflationary pressures also began to ease. By early 2024, CPI readings had fallen back near pre-pandemic levels, when face coverings were not yet a cultural norm. The key question now is whether the inflation spike has been fully brought under control.

While corporate pricing strategies and consumer behavior—both central drivers of inflation—are inherently difficult to forecast, it remains possible to analyze the components of the CPI and examine the historical forces that have shaped inflation trends.

A Framework for Understanding Inflation

Unsurprisingly, the team at Ned Davis Research Group has already taken this step. In short, there is indeed a model that addresses this—shown below.

The upper chart shows the Consumer Price Index, which represents the inflation rate, while the lower chart displays NDR’s Inflation Timing Model. Reading the model is fairly intuitive. When the blue line rises above zero, it signals that inflation pressures are likely increasing. Historically, readings above 10 have coincided with periods when inflation was significantly above normal levels.

The red box highlights the CPI period from late 2020 through early 2022. During that phase, the model effectively flagged the acceleration in inflation and warned that conditions were set to deteriorate. The model also performed well in the opposite direction in the fall of 2022. While widespread concern about inflation persisted, the model correctly indicated that inflation was poised to ease—and it did.

That downtrend continued until late 2024 or early 2025, when the model briefly suggested inflation was no longer moving in the right direction. However, the signal proved temporary, as the model dropped back below the zero line by the end of 2025. Encouragingly, recent data has validated the model’s current reading, with price pressures generally moderating and the inflation rate falling back below 3%.

Is 3% Becoming the New Inflation Norm?

Inflation skeptics are quick to push back against my relatively calm view, pointing out that inflation remains well above the Federal Reserve’s stated 2% target. From that perspective, they argue the Fed is unlikely to turn accommodative anytime soon. While this logic is understandable, it overlooks two important points: first, the Fed operates under a dual mandate, and second, its preferred inflation gauge—core PCE—differs from the inflation measures most often highlighted in the media.

Crucially, inflation is not the Fed’s sole concern. Maintaining a healthy labor market is equally central to its mission. As a result, the Federal Open Market Committee must carefully balance inflation pressures against broader economic conditions.

This helps explain why the Fed has been cutting interest rates even as inflation remains above target. The labor market has shown signs of weakening, prompting policymakers to act. Equity bulls have welcomed these moves, mindful of the long-standing adage that it rarely pays to fight the Fed. With rates coming down, investors have largely aligned with the bullish camp.

That said, it’s important to recognize that the Fed is not engaged in an aggressive stimulus campaign. Chair Jerome Powell and his colleagues are not attempting to jump-start the economy. Instead, they are seeking to bring interest rates back toward a more neutral, “normal” level—one that balances inflation with labor market stability.

In this context, the prevailing view is that the Fed is willing to tolerate inflation running somewhat above its 2% target while it works to shore up employment conditions. From that standpoint, an inflation rate around 3% may be acceptable—for the time being.

In Summary

The encouraging takeaway is that history suggests a modest amount of inflation can actually be beneficial—supporting stock prices, home values, and corporate earnings. From that perspective, inflation does not appear to be a headwind for equities at present. While this may not be a classic “don’t fight the Fed” environment, the central bank is also not acting as an adversary. As a result, my view is that investors can remain on the bullish path—for now.

Sources: David Moenning