Reinvigorated
Key Takeaways
Federal Reserve Interest Rate Outlook and Inflation Trends
Expectations for interest rate cuts by the Fed have nearly vanished in the wake of the large job gains (and upward revisions) reported for May. We agree. A rate hike is next, possibly as soon as late summer.
The combination of stronger job growth and inflation well above the Fed’s 2% target eviscerates the case for the Fed to reduce interest rates. It is possible that AI will lower costs and serve as a headwind to inflation. But that process will take time. More immediately, economic growth is absorbing slack and counterproductively preventing any meaningful moderation in inflation.
The Middle East situation is unlikely to rescue the Fed. If the war with Iran is settled soon, an iffy assumption, reopening the Strait of Hormuz and allowing crude oil prices to decline, the reduced cost of energy will turbocharge consumer and investment spending. Overall inflation may slow, reflecting lower oil prices, but stronger demand will add to underlying scarcity and inflation. The case for any moderation in underlying inflation pressures is weak. The risk actually goes the other way. And if the war lingers, oil prices could rise in response to declining inventories. That would weaken growth, even as it boosts reported inflation.
Economic Growth, AI Investment, and Labor Market Strength
How did we get here? Looking back, 2025 was a soft patch, as President Trump’s tariff, border and government headcount reduction policies nearly offset domestically led growth. Hiring was barely positive. Growth was led by gains in productivity and rising corporate profitability, with AI investment the bright star. As the headwinds receded, underlying growth trends re-emerged. It seems very likely that the job gains reported for May benefitted unusually from the upcoming World Cup. But such a judgment misses the underlying trends, so it also misses the point. AI spending is very strong, corporate profits are rising rapidly, and these tailwinds are now propelling the economy to grow close to or above its potential growth rate. Reducing inflation in a solid growth economy with an unemployment rate of 4.3% is unrealistic without a tightening of monetary policy.
“More immediately, economic growth is absorbing slack and counterproductively preventing any meaningful moderation in inflation.”
CIO & Co-founder, Dr. Charles Lieberman
Investment Implications of Higher Interest Rates
Interest rate hikes by the Fed should not be viewed overly negatively, since they reflect the strong growth of the economy, although they do provide headwinds to the stock and bond markets. Strongly rising profits provide a powerful offset to higher discount rates in valuing stock prices. Shortening duration provides an effective defense against rising interest rates.
Stock Market Valuations and Earnings Growth
Stock valuations remain an issue for some people. Yes, valuations are historically high for various indices, like the S&P 500, but so is profit growth. As my colleague, Paul Broughton pointed out recently, excluding a small number of highly valued stocks reveals that the rest of the S&P trades around 17 to 18 times forward earnings and around 185 stocks trade at 15 times or less. It is not necessary to pay up for good value. So, stock valuations don’t appear to be a reason for concern, at least not at this time.