The Key to Lower Inflation May Start with Stock Prices

Published on March 24, 2025

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The key to lower inflation may start with the stock market and feed into the economy rather than vice versa. The wealth effect describes the behavioral phenomenon where individuals' perceived wealth changes impact their spending decisions. People tend to feel wealthier when their asset prices rise, even if their income remains unchanged, leading to higher consumption. Of course, this works in the opposite direction as well.

The wealth effect is particularly relevant to higher-income households today. According to S&P Global, the top 10% of households by wealth held nearly 88% of stock and mutual fund shares as of Q3 2024. Furthermore, according to the Wall Street Journal, roughly 50% of all consumption in the US comes from the top 10% of American earners. Accordingly, the wealth effect may be the first domino in a chain of events that brings inflation back toward the Fed’s target. Per the WSJ:

The Harvard economist Gabriel Chodorow-Reich estimates that with all else equal, a 20% drop in stocks in 2025 might reduce growth by as much as a percentage point this year.

As of Friday's close, the market had retreated roughly 8% from the February peak. We certainly aren’t implying that we believe a 20% market decline is coming this year. However, a moderate, sustained market correction could be the Trump administration's key to solving the inflation puzzle.

The Key to Lower Inflation May Start with Stock Prices

What To Watch Today

Earnings

No notable earnings reports today

Economy

Market Trading Update

Last week , we noted that the market performance, while distressing as of late, has been well within regular correctionary market cycles from a historical perspective. To wit:

"While Trump's tariffs and bearish headlines currently dominate investors' psychology, we must remember that corrections are a normal market function. Yes, the market is down roughly 9% from the peak, but we have seen these corrections repeatedly in the past. That does NOT mean a more extensive corrective process is not potentially in process. It only implies that markets are likely in a position for a technical rally to reverse the more extreme oversold conditions. As shown, the MACD and relative strength are currently at levels not seen since the October 2022 lows. Furthermore, the market has completed a 23.6% retracement of the rally from those lows, providing the support needed for a rally."

The market tried to muster a rally this week, and we are beginning to see early signs of a bottom forming. As shown in the chart below, while bumpy, volatility has fallen below 20, relative strength has improved, and momentum is turning into a buy signal. Furthermore, money flows are also beginning to reverse, suggesting a near-term bottom may be in.

However, even with that technical improvement, while meager, let me reiterate what we said last week.

"Let me be clear. I am not saying the markets have bottomed, and the next move is back to all-time highs. While that could be the case, other technical warnings suggest we could be in for a longer corrective/consolidative process. As such, we recommend using rallies to rebalance portfolios, reduce risk and leverage, and increase cash levels slightly until the markets confirm the bullish trend is re-established."

The last part of that statement is the most critical. Nothing in the market is guaranteed. Therefore, we must continue managing risk accordingly until the market's direction is revealed. When that will be, we are uncertain, so we contin

The Week Ahead

This week features several economic data releases after last week’s FOMC meeting, during which the Fed held rates steady and adopted a dovish tone. The main event comes on Friday with PCE prices, the Fed’s key measure of inflation. Forecasters expect both core and headline PCE prices to rise 0.3% MoM in February, commensurate with January. Core PCE inflation, shown below, remains sticky above the Fed’s target. The consensus estimate for personal income is a 0.4% increase MoM, down from 0.9% in January. Meanwhile, the consensus expects personal consumption to improve to 0.6% MoM from -0.2% in January.

This morning features the February Chicago Fed National Activity Index and the March S&P Global Composite PMI Flash. The composite PMI has declined for two consecutive months, being led lower by the services PMI. Tomorrow, the CB Consumer Confidence index will be updated for March. Forecasters expect confidence to continue declining for the fourth consecutive month to 94 in March from 98.3 in February. Wednesday, Durable Goods Orders for February hit the tape. Finally, Thursday will bring the final estimate of the fourth-quarter GDP data.

U.S. Recession Risks Not as High as the Media Suggests

The one thing you can always count on during a sell-off is the media trying to formulate a headline to rationalize investor actions. During this particular decline, it was the return of a U.S. recession.

Of course, it is wise to remember that in 2022, we had the most anticipated recession ever, which failed to occur and preceded one of the strongest bull markets in recent history.

The problem with predicting recessions is that economists always work off of lagging economic data. Such is particularly the case with GDP, which is revised three times following the end of the quarter, 12 months, and 3 years later. Historically, given that lag, the timing of U.S. recessions can be off by 9 to 12 months before they are recognized by the National Bureau of Economic Research (NBER). The chart below shows the lag between the onset and recognition of previous U.S. recessions.