Not everyone agrees that the Federal Reserve's anti-inflation task has been completed. When it comes to interest rate cut expectations, whoever is wrong will be in trouble.

Most Wall Street insiders believe that inflation has been conquered. If they are wrong, they will face significant risks.

Unexpectedly lower inflation data has recently driven a substantial rebound across the entire market, with traditional stock and bond portfolios achieving the highest returns in the past 30 years last month. Some investors believe that the Federal Reserve is currently moving towards its 2% inflation target, thereby increasing bets on interest rate cuts starting next spring to prevent an economic recession. This would mark the end of the anti-inflation actions that have been suppressing the market since early 2022.

Nevertheless, the Federal Reserve's preferred PCE inflation indicator remains around 3% year-over-year, leading some investors to worry that inflation may struggle to return all the way to 2%, making stocks and bonds prone to pullbacks.

Reasons for optimism:

The United States actually has numerous measures of inflation. The Federal Reserve's official target is 2% overall PCE inflation. However, Federal Reserve officials pay more attention to core PCE and also track three-month and six-month price changes to understand the latest inflation dynamics.

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The recent performance of these data has excited investors. Core PCE inflation remained around 3.5% in October. But on an annualized three-month basis, it was only 2.4%. Some analysts say that as the impact of the pandemic continues to recede, inflation will continue to decline.

A significant driver of inflation in 2021 and 2022 was everyone spending money on the same consumption at the same time. First, it was goods, when people were confined at home with government subsidy funds in hand. After concerns about the pandemic subsided, consumption collectively shifted to services such as travel and dining out.

Jefferies U.S. economist Thomas Simons said that this herd behavior has now dissipated, leading to reduced pressure in both inflation categories.

He also said that another consequence of the pandemic was that many older workers left their jobs and were replaced by less experienced employees. This dragged down productivity, making it harder for businesses to meet surging demand, further driving up prices. Employers competing for qualified applicants also drove up wages. However, productivity has since normalized.Many analysts also believe that the Federal Reserve's interest rate hikes are still impacting the economy. Higher interest rates increase borrowing costs, which helps to curb inflation. As employers reduce hiring and wage growth slows, households and businesses are more cautious in their spending.

Despite the economy picking up speed in the third quarter, overall economic growth has been slower than before the pandemic since the Federal Reserve began raising interest rates. Growth is expected to slow down again in this quarter.

The labor market has also unexpectedly remained strong, with the unemployment rate still near a five-year low. However, it has been cooling in the way the Federal Reserve wants: job openings are decreasing, and fewer people are resigning, which helps to control wage growth.

In addition to the aforementioned fundamental factors, the peculiar way inflation is calculated can also lead to further declines in data. The housing component in the PCE inflation data reflects the current cost of housing, which accounts for a large proportion of overall inflation data. However, the decline in rent prices takes time to be reflected in inflation data. As the growth rate of rent on rental advertisements slows down, it will gradually start to be reflected in housing inflation.

Brian Rose, Senior US Economist at UBS Global Wealth Management, said that when the Federal Reserve first started raising interest rates, many people believed that inflation was so high that it was impossible to reduce inflation without falling into a recession. But he now believes that the possibility of a soft landing is very high.

Reasons for pessimism

The progress in inflation is decisive enough that most investors believe that the rate hike has ended. However, many people say that the market underestimates how long the Federal Reserve will keep interest rates at their current level.

Pessimists believe that the economy has indeed cooled down - but not enough. For example, job openings are still higher than before the pandemic. As a key driver of inflation, wage growth is still high. One of the factors that continue to put pressure on wages is people's inflation expectations. From some indicators, this number is still high, which may prompt workers to continue demanding higher raises.

Andrew Hollenhorst, Chief US Economist at Citigroup, said that assuming productivity grows by 1% per year, the current wage growth seems consistent with inflation of around 3% to 4%.

This could make it particularly difficult for service industry inflation to continue to decline, as service industry inflation is often closely related to wages. Hollenhorst said that, for example, hotel prices have recently decreased, but they should eventually rebound again.More importantly, the easing of the financial environment could become one of the reasons for the return of inflation. The expectation of interest rate cuts has led to a significant decline in U.S. Treasury yields, and the rise in the stock market has reduced the financing costs for businesses. Investors become wealthier, which may stimulate them to increase spending, once again driving inflation to rise. The Goldman Sachs U.S. Financial Conditions Index has recently declined and is below the level reached before the pandemic, when inflation was chronically below the Federal Reserve's target level.

Blerina Uruçi, Chief U.S. Economist at T. Rowe Price's fixed income department, expressed her concerns about the impact of the market surge. She believes that, given the resilience of the economy, further easing of financial conditions may "stimulate demand, thereby reigniting price pressures."