By Jacob Sonenshine

The stock market's rally is largely rooted in one major assumption: Tariffs won't spur too much inflation.

The S&P 500 is up more than 10% this year, hitting several new records, in a gain that includes most of its sectors. Driving the gains are companies' stronger-than-expected outlooks this earnings season and the expectation that the Federal Reserve will cut interest rates.

This picture only looks so pretty because the market expects tariff-driven inflation to be transitory. There's inherent risk in that bet, given that both the market and the Fed thought the postpandemic inflation in 2021 wouldn't last. Then, price growth sped up in 2022 and the Fed had to lift interest rates to cool the economy, causing the S&P 500 to fall 25% during that year.

Today, inflation remains above the Fed's 2% goal. The core personal consumption expenditure index, which excludes volatile food and energy costs, rose 2.9% year over year in July, over an average of 2.4% for the past three months, including July. Consumer prices crept up last month, partly because companies have continued to lift prices as they confront higher product costs from tariffs.

And still, the market has a point in envisioning cooler inflation. That argument is as follows: Import levies will bring a one-time increase to the cost of goods -- and the prices consumers pay -- this year. Any percentage increase will likely be smaller in 2026 because prices are already elevated.

Chris Senyek, chief investment strategist at Wolfe Research, asks in a recent note, "Is 3% the New 2%?" His point is that, if overall inflation is close to 3% right now, that makes something closer to 2% realistic in 2026, given the year-over-year comparison.

Another factor supporting that thesis is that rental prices will continue recent weakness. The average U.S. rental price has fallen year over year in the past few months, according to Zillow. House price increases have slowed to the low single digits in percent terms in recent months, too. Subdued shelter prices will limit inflation because shelter is one of the largest components in many broad gauges of U.S. prices.

"The market is assuming that over the coming quarters the recent and continued weakness in housing prices/rents will more than offset the tariff impact of higher goods prices with the latter being more one-time in nature than a permanent change in inflation expectations," writes Senyek.

If that's true, it's easy to understand why markets keep partying. Transitory inflation would make it easier for the Fed to lower rates beyond September to support the economy. Next month's rate cut is almost a shoo-in, but the federal-funds futures market sees additional cuts after September as more likely than a pause. Sure, if tariff-driven inflation continues to show up after September -- perhaps keeping inflation closer to 3% -- that second rate reduction might not come quite so soon. But maybe it will come next year if inflation dips closer to 2% then.

"The path for rates is likely biased lower after September, but the cadence remains highly uncertain," writes John Belton, portfolio manager at Gabelli Funds.

Aside from the Fed, the idea that the effect of tariffs will moderate next year supports companies' profit margins. Their product costs won't rise as much next year because those expenses will be compared with 2025's already elevated expenses. Sure, companies might not aggressively lift prices, but overall, analysts expect many companies' gross margins to stabilize after this year.

A perfect example is e.l.f. Beauty, which reported lower gross margins year over year to 69.1% in the second quarter. But analysts forecast those margins will hold steady and rise to 69.4% for 2026, according to FactSet. So as long as e.l.f. continues to grow sales, its earnings can grow next year.

Of course, there is a counterargument: Tariff-driven inflation might not be a one-time occurrence. For instance, if consumers have grown accustomed to inflation, they could ramp up purchases of goods and services before prices rise too much. That could create the sustained inflation people are afraid of in the first place. (The rebuttal to that risk is there's only so much money people can spend, especially since job gains have slowed down.)

Continued price growth could change the Fed's rate trajectory, too, disappointing investors in the near term. If the Fed can't lower rates a second time in the fourth quarter, traders might take their profits in stocks by selling, pressuring the market. But any such decline would likely be mild if inflation remains relatively tame next year. Then, investors would likely would regain confidence that the Fed will cut again, supporting continued economic expansion and corporate earnings growth.

For now, the stock market keeps chugging higher. It might keep doing that -- as long as there is no clear evidence that inflation can remain higher for longer.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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August 31, 2025 02:00 ET (06:00 GMT)

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