Analysis: Assessing inflation’s impact

On a year-to-year basis, inflation continues to move in the right direction. However, in recent months, living costs trended modestly higher. For the 12-month period ending in December 2024, the Consumer Price Index (CPI) rose 2.9%, a 0.5% increase from September’s level.¹

“Notably, the headline CPI number is still below 3%,” says Rob Haworth, senior investment strategy director for U.S. Bank Asset Management. “While CPI has drifted modestly higher, we’re not seeing significant inflation acceleration, and that’s a positive sign.” Higher energy costs were a major contributor to December’s CPI uptick.

The Federal Reserve (Fed) closely monitors inflation as it determines interest rate policy and other monetary strategies. Earlier in 2024, when inflation appeared to level off but the job market signaled potential weakness, the Fed began cutting short-term interest rates for the first time in four years. Between September and December 2024, the Fed cut rates three times by a total of 1.00%.

Despite the recent climb in headline inflation, Haworth says underlying data is generally favorable. “The Fed is looking at some ‘below-the-radar’ measures that focus more on core costs, which are raising few immediate concerns,” says Haworth. For example, when eliminating the volatile food and energy sectors, so-called “core” inflation numbers are more encouraging. The core inflation calculation still includes, among other categories, costs for housing, transportation and medical care. December’s inflation report showed core inflation growing by 3.2% over the previous 12 months, its lowest level since August 2024.¹

The biggest price changes in the past 12 months occurred in transportation services (+7.3%) and shelter (+4.6%). Energy costs were relatively flat (-0.5%) compared to a year earlier while food prices rose just 2.5% over the same 12-month period.¹

New inflation variables?

2021 and 2022’s high inflation prompted the Fed to raise interest rates by more than 5% in a little more than a year, ending in mid-2023. The Fed reversed course and began cutting the short-term federal funds target rate in September 2024. However, Fed officials recently announced that 2025 rate cut plans were scaled-back. It projected only another 0.50% of cuts in the new year, depending on future economic data trends.² Equity market fluctuations in late December 2024 and 2025’s early trading days reflect concerns that the Fed will hold the line on interest rate cuts.

In light of the Fed’s outlook and signs that the labor market appears to have regained strength in recent months, markets see little likelihood of a rate cut at the Fed’s January 28-29 policy-setting meeting.³

What’s less clear are factors that could affect inflation going forward and how it might impact Fed policy. The new Trump administration is floating plans for significant tariff increases on products imported from three key trading partners, China, Mexico and Canada. “The magnitude of tariffs currently being proposed, from 10% to 25%, are well beyond previous tariff levels,” says Haworth. “This could push prices higher.” In addition, if Trump, backed by a Republican-led Congress, implements planned tax cuts that could stimulate economic growth, which could also be inflationary.

Favorable, long-term inflation trend

The Fed has indicated a desire to return the fed funds target rate to what it considers a neutral range, although, according to Haworth, “It’s not clear if the Fed now considers its neutral level to be 3% or 4%.” Prior to the Fed’s late January 2025 meeting, the rate stands at the 4.25% to 4.50% range. The Fed targets 2% inflation, as measured by the annual change in the personal consumption expenditure (PCE) price index, a measure of spending on goods and services.⁴ Progress on meeting the Fed’s 2% inflation target stalled in recent months. PCE moved slightly higher in October and again in November, with the headline PCE index at 2.4% for the previous 12 months, compared to 2.1% for the 12 months ending in September. The narrower “core” PCE (excluding the volatile food and energy categories) stayed steady in November at 2.8%, the same as October.⁵

“Though core inflation prices remain higher than overall inflation, the Fed can live with that assuming, as is the case for now, that core costs remain level,” says Haworth.

After soaring in 2021, inflation as measured by CPI, has declined in three consecutive years, though it remains above levels consistently achieved between 2009 and 2020.⁶

A variety of factors could come into play that determine inflation’s future path. “There’s a lot of questions about the impact of changing government policy, such as potential higher tariffs,” says Haworth. “Other factors such as the ability of consumers to continue to boost economic growth will have a hand in how much the Fed feels it needs to cut interest rates or whether it needs to shift direction.” Haworth points out that if the economy maintains a solid growth pace, the Fed will likely not feel the urgency to act.

How inflation can impact your portfolio

As inflation leveled off in 2023 and 2024, equity markets responded favorably. In 2024, the S&P 500 registered its second consecutive year of 25%-plus total returns.⁷ Investors may want to consider an overweight allocation to equities relative to fixed income investments, while retaining a neutral weight in real assets.

At the same time, it’s important to remember that a consistent long-term strategy tends to work to the benefit of most investors. This likely precludes any dramatic changes to your asset allocation strategy in response to today’s capital market environment.

Be sure to talk with your financial professional about what steps may be most appropriate for your situation.