December 3, 2025
The Federal Reserve mandate is to promote maximum employment and stable prices. They achieve this through monetary policy. The Federal Reserve wants economic conditions that support job growth as well as having low and stable prices.
The employment part of the mandate has been the focus recently at the Federal Reserve as the rate has been slowly moving higher. The recent low was 3.4% in April 2023 and it is now at 4.3% as of August 2025. However, the 25-year average is 5.7%, so it would suggest that the unemployment rate is still very low historically. Inflation, (Consumer Price Index (CPI) and Core Personal Consumption Expenditures (PCE)) is still above its 25-year average. CPI is at 2.9% and the 25-year average is 2.6% and core PCE is at 2.88% and the 25-year average is at 2.10%. Inflation statistics are close to the Fed’s goal of 2% but not quite there. Do we need to get to a 2% target rate to say inflation is at low and stable prices or has inflation been imbedded in prices long enough after the pandemic that the targeted inflation rate should be higher?
The 2% inflation target is a widely agreed upon level among both policymakers and market participants born out of a New Zealand central bank paper from the late 1980s. This target is a compromise suggesting that it is low enough to maintain purchasing power but high enough to avoid the consequences of deflation. This target was really agreed upon by Fed officials when inflation was seriously below 2%. The last five years have seen inflation above 2% although it has dropped quite a bit from the high inflation rates of 2021-2022, but it has stubbornly been above the 2% rate.
In a previous post, we highlighted the inflation breakeven rates which is the difference in yields between Treasury Inflation Protected Securities (TIPS) and nominal Treasury securities. The “spread” is the inflation expectation for a given maturity. When looking at the 2-year to 30-year inflation expectations, they are all above the spreads that they were trading at prior to the Covid shutdown. For example, the 2-year inflation expectations were between 100 basis points and 200 basis points (1% to 2%) and they have recently been in a range between 200 basis points and 300 basis points since September of 2022. The 10-year breakeven rates were a little more volatile prior to Covid, mainly between 150 basis points and 225 basis points. Since June of 2022, they have settled into a range of 200 basis points to 250 basis points.
There are examples of higher inflation in other data. Average hourly earnings prior to Covid were 2.4% to 3% and currently in a range of 4.25-4% even after all of the Fed adjustments to monetary policy. The University of Michigan Expected Price Changes in the next year were 2.1% to 3% prior to Covid and are now at 4.8%. It's been a challenge to get the inflation rate down to the 2% level, yet the Fed is confident it will get there.
However, in this current monetary, fiscal, and political environment, is 3% inflation the new 2%? Part of the stubbornness of sticky inflation is being driven by the concerns of higher tariffs imposed by the government. Tariffs typically lead to one-time price adjustments and tighter margins for companies who initially eat the increased costs. The spending public is still sensitive to price increases stemming from the memories of the pandemic inflation and any price shocks has them pulling back from spending. A 3% inflation rate may not be so terrible when adjusting for fiscal deficits, massive supply of treasury debt and a Federal Open Market Committee that is divided and subject to pressure from the administration.
The reason to discuss this is the effect of a higher inflation rate on equity multiples and interest rates, specifically 10-year rates. If inflation stays sticky around 3%, this suggests the 10-year rate is of fair value between 4% to 4.25%. For equities, here is a very simple table:
Inflation P/E ratio
0‒2% Tends to be highest
2‒4% Healthy but inflation at the higher end will pressure multiples
4‒5% Ratios compress and uncertainty of earnings rises
With inflation around 3% forward P/E should be in the low to mid 20s.
The last 1% of disinflation is proving to be difficult, and we need to at least price in the risk inflation doesn't fall further. If it doesn’t, don’t look for much more Federal Reserve easing short-term rates. The 10-year rate probably ranges between 3.85% and 4.30%, and the equity market will have to rely on non-monetary policy factors to grow earnings.