Riding the Wave of Growth and Inflation

The strong economic growth and inflation experienced recently are sustainable, and they’re being underestimated by investors and the Federal Reserve. Market prices indicate investors expect a quick return to the pre-pandemic combination of modest growth and low inflation.

Fed officials repeatedly say that’s what they believe will happen. Forces supporting growth and inflation are in place and re-enforcing each other. Thanks to fiscal stimulus and other factors, households are in their best financial shape since before the financial crisis. They’ve been able to reduce debt and increase savings, and they benefited from rising prices for stocks and homes.

Low interest rates brought household debt service levels to new lows. The tight labor market is increasing incomes. The 12-month increase in overall wages recently was 4%, the highest level in more than a generation, and increases for some sectors are much higher. B

usinesses continue to report that hiring enough qualified workers is their biggest problem, and the number of unfilled job openings exceeds the number of unemployed workers. That means wages will continue to increase. Surveys of businesses indicate most are raising pay and passing the costs on to customers.

(Though wages have increased rapidly, the increases for most workers still lag inflation.) Credit card data shows spending continues to grow, and consumer surveys indicate people are likely to spend more in the coming months. The strong demand from consumers is stimulating spending by businesses to meet demand. Plus, businesses are investing in equipment and other capital goods at a strong pace.

During the recent earnings season, we learned that businesses have a lot of cash and substantial unused lines of credit. Surveys of businesses indicate these resources will be spent on higher salaries, more workers and capital investments.

Strong growth following the recession led to supply and demand imbalances that pushed inflation to its highest levels in decades. Some of the imbal-ances (such as for lumber and used cars) already are receding. But many imbalances will last into 2022.

Adjustments to the imbalances will bring the inflation rate below its recent peak, but inflation is likely to settle well above the pre-pandemic rate for a while. The Fed made clear that it won’t be alarmed by higher inflation and rapid growth, because it expects those trends to be transitory. But while some of the recent inflation was caused by imbalances that will be corrected, other forces pushing inflation higher won’t recede so quickly, and some will surge.

For example, housing prices have been rising rapidly over the last year because of low supply and high demand for homes, which will continue. But home price increases aren’t yet reflected in the inflation data. The Consumer Price Index (CPI) uses rents to measure housing inflation. The surge in home prices hasn’t been reflected in rents yet, but it will be in the coming months. Only then will housing inflation appear in the CPI.

All these factors make it unlikely growth and inflation soon will return to pre-pandemic levels. The main risks to the economy are that the spread of the Delta variant of COVID-19 might cause consumers to restrict some of their activities or governments to re-impose broad lockdowns.

That could happen either in the United States or globally. Sustained strong economic growth is good for most stocks. It also is good for commodities. The likelihood that inflation will remain elevated is good for a basket of inflation hedges: gold, real estate investment trusts (REITs), commodities and Treasury Inflation-Protected Securities (TIPS).

For now, it appears that the stimulus of 2020 created sustainable momentum in both growth and inflation. The momentum should continue unless disrupted by external factors such as central banks tight- ening more than expected, substantial tax increases, geopolitical conflicts, or adverse developments in the pandemic.