The simplest explanation as to why stocks are having a solid year in 2018 is because inflation has been tepid. Inflation is high enough to push real wage growth negative and come close to matching the cycle high, but it isn’t high enough to cause the Fed to hike rates quickly. The economy is in the 9th year of the expansion and Q2 GDP growth was 4.2%, yet year over year core PCE only matched the Fed’s 2% target. The economy is at the point where it should be exuding increased inflation, yet the Fed still has what it considers accommodative monetary policy.

It’s debatable where the neutral rate is and whether policy is near contractionary. What’s not debatable is inflation’s long term down trend, measured by CPI and PCE. It has fallen to the point where high inflation only barely meets the Fed’s goals. Inflation in Japan and Europe can’t even get that high. While that’s a good problem, their GDP growth is also low partially because of weak demographics. America is in the sweet spot were growth is strong, and inflation is modest. This great situation also had the combination of a cyclical upturn and tax cuts to boost stocks further in 2018.

The US stock market is led by its tech growth stocks. Monetary policy plays a role in this because growth names don’t like inflation. One of the biggest fears about the tax cut was that because the economy is near the end of the cycle, it would create excess inflation. Now that we see inflation isn’t a problem (yet), the biggest worry has switched to how long this period will last. You know the economy is good when both economists and investors agree and are wondering if it can continue.

Inflation Is Expected To Increase Modestly

To be clear, we are basing the lack of inflation on the historical results, which you can see in the top chart below, and expectations for inflation which you can see in the bottom charts.