The battle against inflation rages on, but it's worthwhile despite the pain

The battle against inflation is taking casualties.

Inflation eats into every family's discretionary income. It is an obvious hurdle for the stock market. It is also an inevitable part of longer-term economic cycles.

So, while it's OK to grit your teeth when ordering an $11 bowl of soup, paying $5 per gallon of gas or buying a house with a 6% interest rate on your mortgage, remember that inflation will not remain this high and neither will the financial pain that comes with it.

Over the last 100 years, inflation has averaged 3 to 3.5% per year. The latest Consumer Price Index (CPI) data released on Tuesday showed 8.3% inflation in August from a year earlier. Three primary factors are responsible: The global pandemic and the broken supply chains that resulted; the Federal Reserve's reluctance to tighten monetary policy sooner than it did; and Russia's invasion of Ukraine.

Higher-than-normal inflation is entirely common following periods of strong economic growth, so some inflationary challenges were unavoidable after the longest bull market in history (March 2009–Feb. 2020).

The three triggers listed above combined to make inflation considerably worse. To be clear, however, even the highest inflation in 40 years does not suggest a structural economic failure the way the subprime mortgage crisis did from 2007-2010.

When trying to gauge how vulnerable the U.S. economy may be to inflationary pressures, it's significant that both U.S. companies and U.S. consumers entered this environment especially strong. Americans' debt-to-income ratios have increased this year as cost of living has risen, but personal savings rates skyrocketed during the pandemic and helped provide a larger financial cushion. National unemployment also remains below 4%.

The Federal Reserve's stubborn resistance to raise interest rates in 2021 (when the economy was flying high) was as big a mistake as its labeling of inflation as "transitory." Both look foolish in hindsight, and high inflation is the price we are all paying for those miscalculations. To his credit, however, Fed Chair Jerome Powell has pulled a 180 and has vowed Fed policy will now be "sufficiently restrictive to return inflation to 2 percent."

As we have written before, tighter Fed policy — even at the cost of stock market weakness and a potential recession — is preferable to inflation that remains higher for longer. The Fed's impact on the U.S. economy is incredibly powerful. If Powell remains committed to slaying inflation, it will happen.

There is still ground to cover before we reach the finish line, however. The gap between CPI (8.3%) and the Fed Funds Rate (2.5%) remains wide. There have been eight "tightening cycles" in the past 50 years, and in every one of those the Fed Funds Rate increased to a point greater than CPI. For that to happen, we will need more rate hikes and lower inflation.

Market expectations suggest the following rate hikes from the Fed at its upcoming meetings: 0.75% in September, 0.75% in November and 0.25% in December. If that occurs, the Fed Funds Rate would be 4.25% by year-end.

That may not be enough to declare victory against inflation, but hopefully by then investors can at least feel like they have the upper hand.