From Bad to Worse: The Federal Reserve's May Inflation Forecast Is Terrible News for Stock Investors

It doesn’t take an economist to tell you that Americans are feeling a significant strain on their finances this spring. One of the most noticeable impacts of the ongoing war in Iran is the effect on gas prices.

Americans are paying an average of $4.50 per gallon, up about 50% since the start of the conflict. Fuel prices impact just about everything, and that’s reflected in April’s Consumer Price Index (CPI) increase, which came in higher than anticipated at 3.8%.

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Analysts are now turning their attention to May and beyond, and the Federal Reserve just shared some terrible news for stock investors with its latest inflation forecast.

The facade of the Federal Reserve building in Washington, D.C.

Image source: Federal Reserve. When will inflation subside?

After last month’s spike in inflation, consumers and investors alike may be wondering whether the impacts of the war in Iran and President Donald Trump’s ongoing tariffs are transitory. Without a clear path to fully reopening the Strait of Hormuz, there’s a shortage of commodities that are typically transported through the passageway, putting further price pressure on all sorts of expenses from groceries to airline fares.

At least for the time being, there are no signs of inflation subsiding. The Federal Reserve Bank of Cleveland updated its forecast for May with the most recent data and expects the CPI to climb 4.2% this month. That would be the highest year-over-year increase in the CPI reading since April 2023.

The Cleveland Fed also released its most recent survey of expectations from U.S. CEOs in the manufacturing and services sectors. They see inflation averaging about 3.7% over the next 12 months, up from 3.1% in the previous survey. In other words, they don’t see lower pricing coming anytime soon.

While gas prices and other commodity-linked pricing could come down if supply constraints ease, costs for many everyday goods and services don’t drop as easily. Investors should prepare for another year of inflation exceeding 3%, regardless of how quickly the war in Iran is resolved. However, the longer it goes on, the worse inflation could get.

Historically, relatively high inflation has led to significantly worse outcomes for stock investors.

How do stocks handle high inflation?

The S&P 500 has historically produced an average annualized return of around 10% before inflation. That drops closer to 7% when you factor in inflation.

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But the stock market doesn’t usually offset higher inflation with higher nominal returns. In fact, periods of low inflation generally produce significantly better inflation-adjusted returns than periods of high inflation. There’s a significant drop-off in real returns for the S&P 500 once prevailing inflation rates exceed 3%, based on an analysis of stock market returns and inflation from economist Robert Shiller’s data going back to 1871.

That correlation could be linked to all sorts of causes. High inflation weighs on consumers, which may push them to spend less and slow down the economy. It may prompt the Federal Reserve to raise interest rates, increasing borrowing costs for businesses and making bonds more attractive to stock investors. High inflation also increases the discount rate that investors assign to future earnings, decreasing the amount they’re willing to pay for a stock today.

So far, the S&P 500 has largely avoided the negative impact of inflation. Investors have brushed off the concerns, sending stocks soaring after a huge sell-off in March. The benchmark index now trades near an all-time high as of this writing. The tech-heavy Nasdaq Composite has recovered even faster, as the artificial intelligence stock trend continues to drive the market.

But investors have limited data on the impact of inflation on companies’ bottom lines so far. Inflation remained relatively mild in the first quarter, only starting its ascent in March.

Investors may not see the true impact on many companies until they report their second-quarter earnings in three months or so. The longer inflation remains elevated, the worse it will be for stock prices throughout the rest of the year.

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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

From Bad to Worse: The Federal Reserve’s May Inflation Forecast Is Terrible News for Stock Investors was originally published by The Motley Fool

From Bad to Worse: The Federal Reserve’s May Inflation Forecast Is Terrible News for Stock Investors

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