Low interest rates have helped stocks in the United States and around the world rally strongly since March this year. With recent economic data showing that inflation is likely to stay moderate for some time, the stock market rally is under no threat from a rate hike by the Federal Reserve at the moment.
Stocks continued their rally last week. The Standard & Poor's 500 index rose 1.5 percent to 1,087.68 at the close of the week, hitting a 12-month high of 1,096.56 on Thursday. The Dow Jones Industrial Average rose 1.3 percent, climbing above 10,000 on Wednesday before closing the week at 9,995.91.
Third quarter corporate earnings reports have generally been positive for stocks. Most of the S&P 500 companies that have released third quarter results have beaten analysts' estimates. Investors have been especially cheered by good performances by the large financials like JP Morgan Chase.
Economic data over the past week have also been mostly positive. Industrial production increased in September while retail sales fell less than expected, boosting hopes that a self-sustaining recovery is developing. Not so encouraging though was a fall in the Reuters/University of Michigan index of consumer sentiment to 69.4 this month from 73.5 in September.
Over the medium and long term, however, the performance of the stock market may depend more on the outlook for interest rates. Typically, cyclical bull markets come to an end after the Federal Reserve raises the federal funds rate.
The good news for the bulls is that the latter is not looking likely at the moment. The Federal Reserve has made it clear that the federal funds rate will be kept low for an extended period. Ironically, this is because it expects the economic recovery to be weak. The Federal Reserve will want to keep rates low to help the economy recover. A weak recovery also tends to keep inflation at bay.
Recent economic data show that deflationary pressure has abated but inflation will probably take a while to build up to a level that will trigger a hike in the federal funds rate by the Federal Reserve.
A Labor Department report last week showed that consumer prices in the US as measured by the consumer price index rose 0.2 percent in September. Compared to September 2008, prices were 1.3 percent lower, a slightly smaller decline than the 1.5 percent fall in August.
An index of consumer prices that excludes food and energy, often referred to as the core index, also rose 0.2 percent in September. This index was up 1.5 percent from September 2008, slightly higher than the 1.4 percent increase in August.
For monetary policy, the Federal Reserve focuses on core inflation.
Historically, at cycle peaks and troughs, core inflation usually lags overall inflation. As the accompanying chart shows, the latter appears to be already turning up. Will core inflation also show a positive trend soon?
Probably not. The year-on-year core inflation rate may have picked up slightly in September but usually, a sustained acceleration in the core rate begins only well after the unemployment rate starts to decline (see accompanying chart, where the unemployment rate is on a reverse scale). The unemployment rate in the US, though, was still on a rising trend in September, climbing to 9.8 percent from 9.7 percent in August.
Of course, eventually, even unemployment will turn as the economy continues to recover. Indeed, a Federal Reserve report last week showed that industrial production increased 0.7 percent in September, its third consecutive month of increase.
And that report showed that another measure of resource slack, industrial capacity utilisation, is diminishing. Capacity utilisation rose to 70.5 from 69.9 in August. Capacity utilisation has now increased for three consecutive months. A rising trend in capacity utilisation is usually followed by a rise in inflation.
Still, historically, the Federal Reserve does not raise interest rates until both industrial capacity utilisation and unemployment are showing clear improvement trends (see "Fed funds rate to stay exceptionally low"). That should be some months away.
Therefore, investors can be confident that the Federal Reserve will not undermine the stock market rally with a rate hike for many more months to come.