The Inflation Tradeoff

Doug Walters, CFA

Inflation remains above the Federal Reserve’s target, and recent comments from Fed Governor Kevin Warsh have increased expectations for a potential rate hike. While higher inflation and higher interest rates both create real challenges, investors should remember that successful investing is rarely about predicting the next policy decision. It is about maintaining a disciplined approach that can navigate a variety of economic outcomes.

Editorial illustration of a ship navigating changing economic conditions, representing long-term investing through periods of inflation and interest rate uncertainty.

Contributed by Doug Walters, David Lemire, Max Berkovich, Matthew Johnson

Fed watchers had a busy week. The latest inflation report came in higher than expected. Later in the week, comments from Fed Chairman Kevin Warsh at Jackson Hole were widely interpreted as hawkish. The implication is that markets are assigning a higher probability to a rate hike at the Federal Reserve’s September meeting.

Let’s take these developments one at a time.

Inflation

The report this week was the Fed’s preferred measure, which is the Core PCE Deflator (which excludes food and energy). The print was 3.3%. The Fed’s target is around 2%, so still well above that level. The headline inflation (with food and energy) was 3.7%.

We all have a good sense of the day-to-day implications of inflation… higher prices at the pump, higher costs of everyday household goods. It reduces day-to-day purchasing power. Less obvious (perhaps), is that it also makes planning for the future, like retirement, harder. All else equal, people have to save more for retirement in a higher inflation world.

Rates

The Fed is tasked with keeping inflation in-check. One of the arrows in their quiver to do that is influencing borrowing rates through the Fed Funds rate. At a high level, the theory is if the Fed raises rates, it slows down borrowing, which slows down the economy, which reduces demand, which lowers prices. Yes, it’s a fairly blunt tool.

At a consumer level, higher interest rates can make it harder to afford cars and houses which are often debt funded. For companies, those that rely more heavily on borrowing (often smaller, less profitable companies), will be more impacted which could result in lower valuations.

A Difficult Choice

The Fed has a difficult choice to make, with no clear and obvious best path. If they raise rates, inflation may slow. It also may not, given inflation may be influenced by factors beyond traditional consumer demand, including the massive capital required to support AI infrastructure and continued disruptions in energy markets. In addition, those individuals who rely most on lending, are likely to be hit the hardest. Not to mention that the new Fed Chair is facing significant political pressure not to raise rates.

If they opt not to raise rates, inflation could continue to rise unchecked, and create bigger problems to solve down the road.

Keep Calm and Invest On

For investors, this need not be a moment of capitulation. The ultimate path of inflation and the Fed are unknowable. But there are knowable risks of high inflation. One is that the combination of high inflation and an investment strategy that is too conservative can lead to what we call negative real returns (said in plain English, prices are rising faster than your investments).

That should usually be avoided.

Success in this environment will likely not be defined by trying to outguess an ever unpredictable market. Our approach is twofold:

Build portfolios that we believe can navigate a range of possible market outcomes, and
Help our clients stay invested at a level of risk that is appropriate for them (not overly conservative).

Uncertainty often feels uncomfortable, but it is hardly unusual. Successful investing has never depended on getting every Fed decision right. It has depended on maintaining a disciplined approach, remaining appropriately diversified, and staying focused on long-term objectives when short-term outcomes are unclear.

Inflation may prove more persistent than expected. The Fed may raise rates, or it may not. Either way, our job is not to predict the future with precision. It is to thoughtfully prepare for a range of possible outcomes and continue making decisions that support our clients’ long-term financial goals.

Knowing what you don’t know is more useful than being brilliant.
Charlie Munger

One thing to watch

Last week was all about inflation and the Fed.

This week, we’ll turn our attention from inflation to the Fed’s other mandate – employment, with both the JOLTS jobs report and Non-Farm Payrolls providing some insight into the trajectory of the jobs market. Any sign of weakness could give the Fed some cover for not raising rates.

About Strategic

Founded in 1979, Strategic is a leading investment and wealth management firm managing and advising on total client assets of over $3 billion, as of 6/3/26.

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