We’re in the Peaking Process

Which will break first: inflation, the economy or the Federal Reserve? Futures mar- kets show that investors believe infla- tion is peaking and soon will return to pre-2021 levels.

Investors believe the Fed won’t have to tighten much more, there won’t be a recession, and interest rates will be lower in a year or two than they are now. Slower economic growth would tame inflation, and there are some signs of weakness in the economy that support this optimistic case.

But I’m skeptical that inflation will decline quickly to a rate that will make the Fed comfortable. The pockets of slowing growth in the economy appear to be the result of consumers making choices and shifting their preferences.

Incomes are rising, but prices are rising faster. Retailers report that consumers are spending as much as they did previously but are buying fewer items. Consumers also are shifting spending from goods and services they preferred during the pandemic to more traditional buying patterns. That’s hurting some business- es and making it appear that overall demand is down. Inflation probably will peak this summer. The most extreme supply and demand imbalances have ebbed, and the Fed stopped its stimulus.

But that only means prices won’t increase 8% annually. It doesn’t mean inflation will return to 2%. Shortages of workers and goods con- tinue, and it will take years for many im- balances to be corrected. Some reports of lower sales are due to supply shortages, not reduced demand. Many businesses report they are able to pass price increases to customers. The labor shortage and wage increases are the key to inflation over the next year or two. Wages are increasing at the highest rates in 40 years, because businesses can’t fill all the jobs needed to meet demand.

Workers haven’t been in such a strong position in decades, maybe ever. Higher wages support de- mand for goods and services and allow consumers to pay higher prices. This cycle supports higher inflation until demand de- clines because of much slower growth. The dollar is an important wildcard that’s being over- looked. The dollar is up more than 13% higher against a basket of currencies so far in 2022. That’s an extremely strong move for a currency.

A strong dollar restrains consumer price inflation. If the dollar declines, up- ward pressure on inflation will increase. The Fed’s in a difficult position.

It will take a lot of tightening to bring inflation back to the 2% target. But the Fed doesn’t want to trigger a recession, because it would have few tools to reverse one. The Fed might decide to settle for an inflation rate that’s stable but high- er than 2%.

For example, to avoid a recession, the Fed might stop tighten- ing when inflation settles into a steady annual rate of 3% to 5%. Most stocks and bonds would do well in the optimistic scenario that’s priced into the markets.

But the stocks that did best before 2022 still wouldn’t do well, because the Fed won’t return to its practice of pumping more and more liquidity into the markets and economy. The more likely scenario is that we’re heading into a period of stagflation. That’s when inflation is high but eco- nomic growth is low or even negative.

In 2023, nominal economic growth is likely to be modestly positive, but after adjusting for inflation growth, it is likely to be negative. Bonds and most stocks don’t do well when inflation is high and monetary policy is tight.

But some pockets of the stock market, such as infrastructure stocks, should do well. Investors also should own more in- flation hedges and commodities than usual during this period, as well as widely diversified funds that have the flexibility to change their positions