Inflation was a hot topic even before the consumer price index hit a 40-year high of 6.8% in November. 

“The speed of inflation in moving from zero to almost 7 percent is shocking and unsettling,” Iowa-born economist James Paulsen wrote in a recent newsletter for the Leuthold Group of Minneapolis. 

“Since 1950,” Paulsen noted, “the stock market has generally performed well in the aftermath of major CPI peaks. 

“Following ten of those previous 13 inflation peaks,” he wrote, “the S&P 500 return rose over the next twelve months.” During those 10 periods, he reported, the S&P 500 produced gains that averaged 13%, ranging from 11% to 40%. During the three off-periods, the S&P 500 fell an average of 15%.

“While today’s inflation level is frightening,” Paulsen wrote, “historically, the stock market performance in the aftermath of a prominent inflation peak is quite encouraging. Typically, stocks struggled while inflation rose – not after it peaked.”

Of course, he added, we don’t know today whether inflation has peaked or is still rising. There are arguments on both sides. Paulsen is among those who believe the peak has already passed or will soon. 

In a separate newsletter, he noted several reasons for a positive economic outlook for 2022, including the fact that “annual real-GDP growth probably rose by about 5.4 percent through the fourth quarter of 2021, its strongest December-to-December rate since 1984.”

The consensus among economists surveyed by Bloomberg is that growth will slow to 3.4% this year, although Paulsen said he expects “a very healthy 4.5 percent” growth rate.

“Pent-up demand is more pronounced than at any point since at least 1970,” he explained.

Individuals have a lot of money in the bank, he wrote. “Excess personal savings have ballooned to about $2.2 trillion since March 2020. Never in the post-war era has there been this much dry powder sitting on the sidelines waiting to be unleashed. 

“Stocks, bonds, commodities and home prices all surged,” he continued, boosting total household net worth by trillions of dollars. 

“As supply-chain disruptions get resolved,” he continued, “the U.S. economy is headed for a massive inventory-building cycle.”  

One final positive, he wrote, is that “the economy is likely to be boosted by above-average productivity,” driven by the advantages of working from home and other recent technology advances.

All of which brings us back to inflation, which had been averaging 2% or less for most of the past decade. 

That began to change in April when the CPI jumped to 4.2% and continued to climb to 6.8% in November. (The CPI rate for December was scheduled for release Jan. 12, after this column was written.)

Paulsen wrote that “while inflation is unlikely to return to the Fed’s official 2 percent target,” he does “expect sufficient moderation to calm runaway-inflation fears” and that the CPI rate will fall back to about 3.5% by the end of 2022. 

The inflation surge of the 1970s, which peaked at 13.5% in 1980, was driven by a number of factors that are not present in today’s economy, Paulsen wrote.

Productivity was lagging in the 1970s but is increasing today. Also, the nation’s leading industry back then was automobiles, “where sticker prices rose every year”; today it’s technology, with sticker prices that “usually decline every year.”

Monetary and fiscal policies are also different, in part because officials learned during the latter half of the 20th century what does and does not work. 

Actually, Paulsen wrote, an inflation rate between 3% and 4% might be better than 2%. 

Recent analysis found that most economic measures “were stronger when the consensus for inflation expectations was 3 percent or higher than when inflation was projected to be 2 percent or less,” he wrote. 

It makes sense, he added, because “when consumer- and business-inflation expectations are subdued, outlooks are generally pessimistic, which encourages conservative economic behavior,” while higher expectations produce more activity.