Tag: inflation
Asset Allocation Bi-Weekly – What “Real” Interest Rates Are Telling Us (October 5, 2026)
by Patrick Fearon-Hernandez, CFA | PDF
One of the most important concepts in economics and finance is the “real” rate of return on an investment. The real rate is calculated by subtracting the rate of consumer price inflation from the nominal interest rate, bond yield, or price gain and dividends on a stock. If the nominal return on the investment is more than the rate of inflation over a specific holding period, the asset owner would have increased his or her purchasing power (before taxes). In contrast, even if the nominal return on the investment is positive, it can be less than price inflation. In this case, the asset owner’s purchasing power will have fallen. Expected nominal returns and inflation therefore can have a big impact on the demand for a particular asset. From a broad economic perspective, they can also affect the overall rate of investment and economic growth.
The chart above shows the Federal Reserve’s benchmark short-term interest rate in both nominal and real, inflation-adjusted terms, as well as the 20-year average of the real rate. For each month shown, the real rate is calculated as the nominal fed funds rate less the change in the consumer price index for the year ending that month. In simplistic terms, an investor could consider the real fed funds rate to be relatively high and restrictive to the economy when it is above its long-run average of -0.8%, whereas it could be considered low and accommodative when it is below average. As shown in the chart, the Fed’s attack on post-pandemic inflation lifted the real benchmark rate to its highest level since the Great Financial Crisis (GFC).
Following the pandemic, Fed policymakers were never able to get inflation back down to their target despite keeping real rates high for an extended period. They nevertheless let the real fed funds rate decline to a virtually neutral level in early 2026. This was probably one reason why investors began to sense that the central bank would be forced to start hiking the fed funds rate again, as it finally did in mid-September. As shown at the rightmost edge of the chart, the real fed funds rate is now rising again as the policymakers renew their commitment to lower inflation. The question is whether the real fed funds rate is now high enough to bring inflation down to target. Based on past inflation-righting episodes, we think it remains too low. Absent political pressure to keep rates low, we would therefore expect even more rate hikes.
What about real, inflation-adjusted yields on longer-term debt instruments? The chart above shows the nominal and real yields on 10-year US Treasury obligations as well as the 20-year average real yield of 0.4%. Since 10-year Treasury yields serve as the benchmark for many other long-term debt instruments and investment projects, such as residential mortgage rates or stock purchases, high real yields can have significant impacts on overall demand in the economy and the financial markets. The chart shows that real 10-year yields in the post-pandemic inflation fight weren’t nearly as out of whack as the real fed funds rate. For example, they never went as far above 2.0% as they did before the GFC, which probably helps explain why economic growth remained too strong to bring down inflation. Nevertheless, after falling to their long-run average in early 2026, real 10-year yields are now rebounding quickly. We believe that real yields could continue to rise in response to factors such as fears of future energy prices, strong debt issuance by artificial intelligence firms, and worries about rising federal budget deficits and debt. If real 10-year Treasury yields move above roughly 2.0%, we suspect they could begin to weigh on economic activity and meaningfully slow the AI investment frenzy.
Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify
Asset Allocation Bi-Weekly – #167 “The PCE Makeover” (Posted 8/7/26)
Asset Allocation Bi-Weekly – The PCE Makeover (August 3, 2026)
by Thomas Wash | PDF
The Federal Reserve’s preferred gauge of price inflation is set for a methodological update, as the Bureau of Economic Analysis (BEA) is expected to implement revisions to its price index for Personal Consumption Expenditures (PCE) as early as September. Early estimates suggest the changes will modestly lower measured PCE inflation, potentially easing the path toward the Fed’s 2% target by reducing the index’s sensitivity to the AI-driven stock market rally.
The timing is notable. As shown in the chart below, the Fed has failed to achieve its inflation objective over the past five years, and a downward shift in the index could finally make the target more attainable — both mechanically and in perception.
The revisions to the PCE price index, scheduled for incorporation in the September 30 release, aim to better align the index with actual household spending patterns. Key changes include updates to core inflation calculations and modifications to several categories that have disproportionately influenced recent readings, namely legal services, portfolio management, and computer software and accessories.
The most consequential adjustments are likely to come from portfolio management and software-related components. The BEA will revise its software price index — an area that has been distorted by the surge in AI-fueled demand — by incorporating a broader set of prices, including video game software and web hosting services. This change is expected to lower measured inflation by roughly 0.1 percentage points.
In parallel, the treatment of portfolio management services will shift away from a fee structure tied to assets under management and toward a measure based on firm revenues relative to services rendered. This adjustment is expected to reduce inflation by an additional 0.2 percentage points. Legal services will also be revised, with greater reliance on producer price data, though the impact there is likely to be more modest.
These changes are small but important, since these components have contributed disproportionately to volatility in the core PCE index. While the components account for roughly 4% of the core PCE index, they represent just over 1% of the core consumer price index, underscoring their outsized influence. Their growing weight has amplified swings in measured inflation, complicating the Fed’s effort to return inflation sustainably to target following years of overshooting.
The divergence largely reflects differences in weighting methodology. PCE weights adjust dynamically with shifts in consumer spending, and in recent years, portfolio management services have captured a larger share of expenditures amid rising retail participation in financial markets. At the same time, the recent surge in demand for computing and software has increased the relative weight of technology-related categories.
As a result, the PCE price index has become more sensitive to equity market dynamics. The chart above highlights the close relationship between rising asset prices and the growing influence of these components, suggesting that a portion of recent inflation pressure has been indirectly linked to strong market performance. This relationship has not gone unnoticed by Fed Governor Miran, who has suggested that a strong stock market should not count toward inflation.
These revisions will likely lower recent PCE inflation readings, implying that the Fed may have been closer to its 2% target than previously estimated. The most meaningful adjustments stem from changes to portfolio management and software-related categories, which should moderate the influence that the AI-driven surge in equity and software prices has had on the index.
However, this comes with a trade-off. By dampening the sensitivity of these components, the index may become less responsive to downside moves in asset prices. In the event of a correction, particularly if the AI rally were to reverse, the disinflationary impulse flowing through these channels could be more muted.
In short, the revisions may bring measured inflation closer to target, but they do not necessarily make underlying inflation easier to achieve or sustain at that level.
Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify
Bi-Weekly Geopolitical Podcast – #88 “Excess Capacity and Policy Change” (Posted 6/11/26)
Bi-Weekly Geopolitical Report – Excess Capacity and Policy Change (June 8, 2026)
by Patrick Fearon-Hernandez, CFA | PDF
A key challenge of the big-picture, top-down investment analysis that we do at Confluence is tracing the real-world impact of a country’s economic policy initiatives. Whether policymakers are trying to boost economic growth, bring down price inflation, or achieve another goal, our aim is to figure out if the reform will be successful and the unintended consequences, be they positive or negative. Our ultimate objective, of course, is to determine the implications for financial markets and investment strategy.
One thing we’ve noticed is that many strategists attempting top-down analysis make overly simplistic assumptions about the likely effect of specific policy changes. They often ignore the fact that the same policy can be wildly successful or unsuccessful, depending on the pre-existing economic structure or conditions in place at the time. In this report, we show that one vital issue is the level of excess capacity in an economy. Many vaunted reforms in history were successful only because they were implemented when the economy had plenty of excess capacity to accommodate them. Many then conclude that those reforms would always be successful no matter what. We caution here that a deeper analysis is required to really understand any reform’s success and its financial market implications.
Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify
Asset Allocation Bi-Weekly – #160 “Wars, Price Shocks, and Inventories” (Posted 4/17/26)
Asset Allocation Bi-Weekly – Wars, Price Shocks, and Inventories (April 13, 2026)
by Patrick Fearon-Hernandez, CFA | PDF
Since the launch of the US-Israeli war against Iran on February 28, if there’s been one dramatic feature, it’s that the conflict and official statements about it have shifted dramatically almost on a daily basis. By the time this report is published, the war could be going in a wholly different direction from when we started writing it. Nevertheless, we do think we can make some predictions about how the conflict will affect the global economy over the long term. One such prediction touches on how corporate behavior may change in the future. Specifically, we think the war will spur companies to once again embrace high inventories to shield themselves against supply disruptions and associated price jumps. A broad return to higher inventories will likely have important implications for corporate profitability, facility-site decisions, and stock valuations.
The chart above shows the inflation-adjusted value of US private sector inventories as a share of gross domestic product (GDP) since the end of World War II. Clearly, the overall trend has been for companies to hold less inventory compared with their sales. What explains this? We believe many factors are responsible. For example, the extremely high inventories around World War II and the Korean War probably reflected hoarding at a time of limited consumer sales. Inventory holdings would have naturally fallen as the end of those conflicts allowed for normalized supply dynamics and rebounding consumer spending. At the same time, innovations in transportation quickened delivery times and reduced freight costs, while the information technology revolution improved the ability of firms to optimize inventory holdings. And, as we’ve argued many times before, the end of the Cold War convinced many business managers that global peace was at hand and that competing in the era of globalization required using just-in-time inventory management.
Equally noteworthy, the decline in price inflation since the early 1980s has made inventories less needed. Indeed, the chart above shows a long, steep decline in inventory ratios starting in the early 1980s when the Federal Reserve under Chair Paul Volker hiked interest rates and Congress passed a series of deregulation bills, both of which slashed price pressures on the economy. Just as important, the chart clearly shows how rising inflation in the 1960s and the energy crises of the 1970s prompted a big jump in inventory holdings equal to about 1% of GDP. The chart also shows that after commodity prices surged around 2005, firms boosted their inventory holdings. That inventory investment was short-circuited by the US housing crisis, but once the recovery started, inventories climbed back to almost 14% of GDP.
This review of history suggests that as company management internalizes the commodity supply shocks and rising prices associated with the war in Iran, there will likely be a rebuilding of inventories. More broadly, as it becomes increasingly clear that the war reflects a wider geopolitical change marked by a US retreat from hegemony, global fracturing, and increased international tensions, we think the rebound in inventories could be bigger and longer lasting than the one in the early 2000s. We also believe this trend will extend beyond the US, with companies around the world incentivized to boost their inventory holdings again.
What firms will be most affected? In the chart above, we focus on the US Census Bureau’s current series of monthly business sales and inventory data, in nominal terms, which allows us to trace corporate inventory/sales ratios by sector. The chart clearly shows that the rise in the overall inventory/sales ratio since the early 2000s has come from higher manufacturing stockpiles. This makes sense to us, as supply disruptions and higher costs for inputs and components are probably more important for manufacturers than for wholesalers or retailers. Going forward, we suspect that the Iran war will especially boost inventory holdings at the factory level.
In our view, any broad, sharp rise in manufacturers’ inventories from here on out will have significant investment implications. For example, holding more inventories will tie up more of manufacturers’ capital and increase costs. Investors are therefore likely to put higher valuations on the stocks of manufacturing firms that can better control their inventory levels, all else being equal. Given that the US is now a net energy exporter and has significantly greater levels of secure supplies of oil, gas, and other key commodities, we expect many foreign manufacturers to move production to the US, helping to reindustrialize the US economy and stimulating business for US suppliers. The need to store more inventory could also lead to increased demand and stronger rents for firms that own commercial warehouses. All the same, higher inventories will generally result in a less efficient economy than in the just-in-time world of globalization, so price inflation is still likely to be higher and more volatile than in years past, and the same will likely be true for interest rates.