⚡️Market Strategy Flash
October 30, 2026
Despite an uneventful Federal Open Market Committee (FOMC) meeting, many investors remain fixated on rearview-mirror inflation narratives. Judging by Lisa Cook’s and Beth Hammack’s dissents, as well as the Federal Reserve’s (Fed’s) own near-term inflation projections, a significant cohort continues to see “sticky-price” inflation as a problem requiring monetary restraint.
However, Robert Hall’s and Michael Woodford’s Nobel prize-winning micro-to-macroeconomic frameworks, alongside my empirical work on economy-wide capacity utilization (capu) and output gap changes*, paint a different picture:Core inflation momentum is right where it should be. Given the relative balance between “actual” and “potential” economic activity as well as core inflation responding predictably to the change in the output gap (see the chart below), further monetary tightening is not only unnecessary – It threatens to break lower-quality pockets of the credit and equity markets.
Core Inflation Momentum Is Right Where It Should Be Relative to Changes in the Output Gap
Sources: CBO, FRED, WCG, 10/29/26. Notes: Vertical gray bands = US economic recessions. CBO = Congressional Budget Office. PCE = Personal Consumption Expenditure. Ppts = Percentage points.
1. Woodford’s Framework: Output Gaps & Supply Shocks
Michael Woodford’s foundational insights and Nobel prize-winning contributions to monetary theory provide a simple, yet useful framework for informing and evaluating policy decisions:
“The second factor that governs inflation is the output gap, a concept Woodford introduced to describe the demand pressure in the economy. If the demand pressure is high, which means the gap is positive … prices are pushed upwards. If the demand pressure is too low, which means the gap is negative … prices are pushed downwards.”**
Moreover, Woodford frames how modern central banks should respond to supply shocks, such as rapid energy price spikes or geopolitical disruptions:
- When a negative supply shock reduces “natural” output – or sustainable productive capacity – more than “actual” output, a positive output gap opens without excess demand.
- Unlike outdated 1970s Keynesian models that misdiagnosed supply-side shocks as purely demand-driven overheating, Woodford’s framework highlights that modern stabilization policy must distinguish between “endogenous” or internal demand pressure and “exogenous” or external supply disruptions.
“Not-So-Sticky” Inflation: By Definition, the “Flexible-Price” CPI Could Change Quickly
Sources: FRED, FRBA, WCG, 10/27/26. Notes: FRBA = Federal Reserve Bank of Atlanta. CPI = Consumer Price Index.
2. Empirical Reality: Core Inflation Momentum vs. Output Gap Changes
From my lens, post-1985 economic data reveal that static output gap levels show no correlation to core inflation over time. Rather, the change in the output gap [((Actual Real GDP - Potential Real GDP) / Potential Real GDP) * 100] influences core inflation momentum (see the chart on page one).
- Balanced Capacity: In my view, economy-wide capu momentum sits in neutral territory, signaling that overall industrial and labor resource take-up is roughly balanced. In other words, demand-pull inflationary pressures seem subdued or even non-existent.
- Predictable Trajectory: Core personal consumption expenditure (PCE) inflation momentum tracks changes in the output gap, suggesting that underlying inflation trends generally behave as economic theory predicts.
- “Flexible-Price” Downside Surprise: Headline inflation noise has been driven largely by “exogenous” supply shocks, namely war-related energy pressures. However, “flexible-price” components (6.12%) are far more volatile than their relatively restrained “sticky-price” counterparts (2.82%). Should geopolitical tensions in the Middle East ease and the Iran conflict resolve, “flexible-price” inflation could surprise significantly to the downside (see the chart above).
3. Investment & Asset Allocation Implications:Do No Harm, Fed!
If the Fed over-emphasizes headline inflation noise and keeps hiking amidst normalizing core inflation dynamics, it risks making a policy error that could damage fragile areas of the credit and equity markets, as well as the economy. Indeed, signs of stress have already emerged in September and October.
- Government Bonds: 10-year Treasury yields responded, albeit temporarily, to cooling inflation momentum. Stable core inflation, better valuation, the highest yields in 20 years, lopsided short futures positioning and record retail inflows make a bullish case for bonds.
A Bond Market Rally Could Relieve Inflation- and Rate-Sensitive Consumer Stocks
Sources: FRED, S&P Global, WCG, 10/27/26. Notes: Indices are unmanaged and an investment cannot be made directly into an index. Past performance is no guarantee of future results.
- Consumer Stocks: Runaway inflation fears and Fed rate hikes have placed acute pressure on consumer-related stocks. Peace in the Middle East, de-escalating “flexible-price” inflation and a bond market rally could boost consumer purchasing power, thereby releasing a much-needed “safety valve” for the Consumer Discretionary and Consumer Staples sectors (see the chart above).
*Market Strategy Flash,Signal vs. Noise: Cool “Core” CPI, Hot “Headline” CPI, June 12, 2026.
**The Royal Swedish Academy of Sciences,Microfoundations deliver macro insights, October 12, 2026.
Definitions
NBER Recession: A significant decline in economic activity spread across the economy, lasting more than a few months, as officially designated by the National Bureau of Economic Research. It is determined by analyzing factors like gross domestic product, income and employment.
Output Gap: The difference between actual economic output (Real GDP) and potential economic output (Real Potential GDP), expressed as a percentage of potential GDP. A positive gap indicates demand pressure exceeding sustainable capacity, while a negative gap reflects economic slack.
Real Potential GDP: The Congressional Budget Office's (CBO) estimate of the maximum sustainable output an economy can produce when labor and capital resources are fully employed at high utilization rates, adjusted for inflation.
Economy-Wide Capacity Utilization (CapU) Momentum: A normalized composite indicator tracking annual changes in broad industrial capacity utilization and labor market utilization. It measures whether resource take-up across the economy is accelerating, decelerating, or sitting in neutral balance.
Sticky-Price Consumer Price Index (CPI): A measure of inflation calculating price changes for goods and services that adjust relatively slowly (such as housing, medical care, and personal services). It reflects longer-term, underlying inflation expectations.
Flexible-Price Consumer Price Index (CPI): A measure of inflation tracking items whose prices adjust frequently in response to market conditions (such as energy, food, and motor fuels). It reflects immediate, short-term supply/demand shocks and geopolitical disruptions.
Core Personal Consumption Expenditures (PCE) Deflator: The Federal Reserve's preferred measure of underlying consumer inflation, excluding volatile food and energy prices, to gauge long-run price trends across the U.S. economy.
Natural Output: The theoretical level of economic output that would prevail if market prices were perfectly flexible and aggregate demand was aligned with structural potential supply. Sudden shifts in natural output caused by external disruptions are known as supply shocks.
Gross Domestic Product (GDP): The total monetary or market value of all finished goods and services produced within a country's borders during a specific period. It serves as a primary scorecard to track the overall size, activity, and health of a nation's economy.
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Publication Date: October 30, 2026
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