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Written by Sean Williams for The Motley Fool->
Despite the S&P 500 and Nasdaq Composite powering to all-time highs, a key piece of the puzzle -- inflation -- points to trouble ahead.
The Iran war led to the largest energy supply disruption in modern times, which has wreaked havoc on energy prices.
The Federal Open Market Committee (FOMC) may be forced to act -- and that's not going to make Wall Street happy.
It's a stellar time to be an investor on Wall Street. With rumors swirling of a peace deal between the U.S. and Iran, the benchmark S&P 500 (SNPINDEX: ^GSPC) and growth-stock-propelled Nasdaq Composite (NASDAQINDEX: ^IXIC) screamed to new all-time highs. The iconic Dow Jones Industrial Average (DJINDICES: ^DJI) needs less than a 1% up day to join its peers.
In several respects, the stock market is firing on all cylinders. S&P 500 companies are buying back stock at a record pace, corporate earnings are blowing past Wall Street's consensus expectations (as a whole), and the evolution of artificial intelligence (AI) is fueling growth and excitement among professional and retail investors.
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But things may not be as perfect as the Dow, S&P 500, and Nasdaq Composite have made them appear. Arguably, nothing poses a greater threat to the stock market right now than inflation.
Fed Chair Jerome Powell delivering remarks. Image source: Official Federal Reserve Photo.
The U.S. economy is dealing with two price shocks at the moment: President Donald Trump's tariffs and the Iran war. It's the latter that's having a substantive impact on price changes.
On Feb. 28, U.S. military forces, at Trump's command, began attacks against Iran. Shortly after this conflict commenced, Iran effectively shut down the Strait of Hormuz to commercial vessels, halting the movement of around 20 million barrels of liquid petroleum per day! According to the Energy Information Administration, this represents 20% of the world's crude oil demand and is the largest energy supply disruption in the modern era.
When the supply of an in-demand good or service is constrained, the law of supply and demand tells us that its price rises until demand tapers off. In the wake of this supply disruption, crude oil prices have soared, leading to pain at the pump for consumers.
According to data from AAA, we've witnessed gas prices rise at their fastest pace in more than three decades. On a percentage basis, the increase in diesel prices has been even steeper.
Average U.S. gas prices per gallon on April 30, per AAA:• Regular: $4.30 (⬆️ $1.32 since war in Iran began on Feb. 28) • Premium: $5.16 (⬆️ $1.30 since war began)• Diesel: $5.50 (⬆️ $1.74 since war began)
Before the effects of the Iran war began showing up in economic data, U.S. trailing 12-month (TTM) inflation clocked in at 2.4% in February. One month later, TTM inflation jumped 90 basis points to 3.3%.
Based on estimates from the Federal Reserve Bank of Cleveland's proprietary Inflation Nowcasting tool, things are about to get even uglier on the inflation front. While the projection for April remains unchanged at 3.56% (an estimated 26-basis-point increase from March), the first-look prognostication for May calls for another 33-basis-point jump to 3.89%, as of the May 6 update. If accurate, the Cleveland Fed expects TTM inflation to have risen by almost 150 basis points over three months.
Even if the Iran war were to end right now, the adverse inflationary effects caused by over two months of crude oil supply disruption would be felt for several quarters. Gas prices often decline slowly after energy supply shocks. Meanwhile, the delayed inflationary effect on businesses should begin showing up in economic data in the months to come.
What's particularly noteworthy, now that we have the Cleveland Fed's first look at May's inflation forecast, is that Jerome Powell's final Federal Open Market Committee (FOMC) meeting as Fed chair on April 29 was highlighted by the highest number of dissents in 34 years. Three of the FOMC's 12 voting members opposed a statement that included an easing bias. In other words, a quarter of the individuals responsible for setting the nation's monetary policy have no intention of lowering interest rates.
While it appears the Fed will give the U.S. economy and inflation time to sort out, they may not be able to sit on their proverbial hands for too long.
If the Cleveland Fed's forecast of the Consumer Price Index hitting 3.89% proves accurate, and history tells us that the inflationary effects on businesses tend to lag following energy price shocks (i.e., they'll be reflected in economic data in the coming months), the central bank may have no choice but to act.
Further complicating this dynamic is the upcoming change in Fed leadership. Powell's final day as Fed chair is this coming Friday, May 15. Trump's nominee to succeed him, Kevin Warsh, is expected to be confirmed with a majority vote in the Senate this upcoming week.
Warsh was previously a member of the Board of Governors of the Federal Reserve (Feb. 24, 2006 – March 31, 2011), and his voting record on the FOMC skews heavily toward a hawkish approach to monetary policy.
"If Trump wants someone easy on inflation, he got the wrong guy in Kevin Warsh."@AnnaEconomist pic.twitter.com/FGMfeSqHpU
In simpler terms, Warsh's voting record shows he favors higher interest rates to curb inflation and stabilize prices. Even as the unemployment rate skyrocketed during the Great Recession, Warsh stuck to his ideology and lobbied for the federal funds target rate to remain elevated to curb inflationary pressure. Warsh's presence adds another element that suggests the FOMC is far likelier to raise rates than lower them.
This is terrible news for the second-priciest stock market in history. As of the closing bell on May 6, the S&P 500's Shiller Price-to-Earnings (P/E) Ratio, which has averaged 17.36 over the last 155 years, hit 41.83. That's the highest mark for the current bull market cycle and is within striking distance of the highest-ever reading of 44.19, registered mere months before the dot-com bubble burst.
The prospect of additional interest rate cuts fueling the AI data center build-out is one of the core reasons investors have tolerated historical valuation premiums. But with rate cuts off the table in 2026, inflation forecasts moving decisively in the wrong direction, and the (presumed) new Fed chair being labeled a hawk, a worst-case scenario may be shaping up for Wall Street.
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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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