The Fed Is Fighting Inflation Again. History Says Trouble, but This Time Might Be Different.

In September, the Federal Reserve raised interest rates for the first time since 2023. There's a reasonable chance they could do it again later this month. But even if they don't, the market is pricing in multiple additional rate hikes in 2027.

The labor market added just 29,000 jobs last month, continuing a streak of expansion and contraction over the past year. More concerning for the direction of rates is inflation. In September, the headline rate jumped 0.6% month over month to an annualized 3.7%. That kind of trend won't allow the Fed to ease monetary policy anytime soon.

That creates a potential problem. What happens when the Fed raises rates while economic growth is already slowing?

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History shows an interesting pattern

Three periods over the past few decades featured restrictive monetary policy coupled with slowing growth.

2000-2001

In May 2000, the Fed raised rates to 6.5% to cool an inflation rate approaching 4%. But economic growth was losing momentum and would continue to do so for the next two years. The S&P 500 (SNPINDEX: ^GSPC) ended up losing up to 50% during the tech bubble burst.

2006

GDP growth was strong but slowing at this point. Inflation was under control, but the Fed decided to keep the federal funds rate above 5% through the middle of 2007 even though momentum was fading. By the end of the year, the financial crisis was underway, and the Fed had dropped interest rates to zero by the end of 2008.

2022-2023

Employment growth slowed from its post-COVID-19 surge, but trillions of dollars of government stimulus sent inflation rates soaring. The Fed kept interest rates high and brought inflation back down to more normal levels while avoiding a full-blown recession.

These episodes weren’t identical, but they shared a setup: a slowing labor market while monetary policy stayed restrictive. Two of them, the tech bubble and the financial crisis, ended in significant bear markets. The third didn’t. In 2022-2023, the Fed held rates high, inflation came down, and the economy avoided a lasting recession.

The labor market matters, but so do earnings

Current conditions are that inflation remains well above target, the Fed will have to keep rates at least where they are for the foreseeable future, and the labor market is mixed at best.

If you consider that with respect to historical precedent during past similar situations, it would be easy to say that a significant stock market correction is a real possibility.

But that ignores the corporate earnings picture, which is the one thing that drives long-term stock prices perhaps more than anything else.

Q3 earnings are expected to rise by more than 20% year over year. That trend is expected to continue well into 2027 and beyond as the artificial intelligence (AI) capex spending cycle continues. It's generally much more difficult for stock prices to correct with that kind of earnings growth happening in the background. Plus, the S&P 500 is only trading at around 21 times forward earnings estimates, so valuations aren't really unreasonable.

That's not to say that a correction couldn't happen, but there's more to the story than just inflation and interest rates. There's a much more balanced picture here when you consider everything.

Here's how I'd invest for the Fed's inflation fight

I'd look hard at two ETFs right now.

For the long-term investor, I'd stick with the Vanguard Total Stock Market ETF (NYSEMKT: VTI). Since catalysts for U.S. stocks are pulling in both directions, the best course of action might be to just stay the course. Own the entire U.S. equity market and let your investments keep growing over time while ignoring the short-term noise.

If you want to take a more tactical approach, the Vanguard Value ETF (NYSEMKT: VTV) looks interesting. Not only does it tilt away from many of the megacap tech names that have dominated the indexes in recent years, but it also provides some insurance should the U.S. economy begin trending toward recession. Its heaviest sector exposures are financials, industrials, and healthcare. They're not quite recession-proof, but they tend to be big cash generators. And that's the kind of thing you want to consider if you're unsure about the direction of the economy.

High interest rates, rising inflation, and slowing growth can be a scary combination. It's less scary if you know how to prepare your portfolio for it.

David Dierking has positions in Vanguard Morningstar Total Stock Market ETF. The Motley Fool has positions in and recommends Vanguard Morningstar Value ETF. The Motley Fool has a disclosure policy.