Financial markets in 2022: Aggregate demand and inflation.

• Author: Rhoads, Russell

The stock market is at historic highs. As of this writing, the value of all common stock is a little over $48 trillion. That is 32% above where it was just one year ago. Certainly some of this stunning return is due to recovery from the damage done by the pandemic, but not all of it. Over the past five years, we have seen a compound growth rate of 15.9%. This is one of the strongest five-year periods in U.S. financial history. We have had two very different political administrations, a politically divided country, a pandemic, trade wars with many countries and growing inflation, not to mention supply chain bottlenecks, riots and increasing crime--and the stock market keeps adding value. Just five years ago, the market was worth $23 trillion.

What accounts for this creation of wealth and will it continue? We humbly admit that we did not forecast this high of a rate for wealth creation and are not exactly sure why we were wrong. Nevertheless, we have opinions! We believe the following factors were important.

First, the Federal Reserve has kept the money supply growing with a low interest rate policy. The federal funds rate has been kept low and the Federal Reserve has kept up purchases of bonds for its balance sheet. Will this continue? The national forecast says that the Fed will cut back purchases of bonds, so we don't expect to be in a low interest rate environment for the near future.

Second, aggregate demand has shifted--especially since the end of the pandemic. The ports may be bottled up, but they are processing a record level of cargo. The creation of weath in the stock market and the lack of spending during the pandemic contributed to increased demand for everything. American firms are responding to this demand. The demand for products has put the entire supply chain under pressure and parts are having difficulty responding. Of course, this has resulted in inflation. It is an ongoing debate how much of this inflation is permanent, but recent figures indicate the level of inflation has overshot estimates and sentiment is moving toward inflation being more than just transitory.

Third, federal fiscal policy has added to the aggregate demand. The federal government has run record (or near-record) deficits during both Republican and Democratic administrations. The Biden administration is trying to dramatically increase the size of the federal government and will add significantly to aggregate demand if successful.

Fourth, the American...