The Impact of Inflation on the U.S. Stock Market after the COVID-19 Pandemic

U.S. inflation in 2022 reached its highest level in more than 40 years (see Figure 1). While it has since fallen, tariffs, tax cuts, and other policies advocated by the Trump administration could cause inflation to re-accelerate (Smith, 2024). This paper investigates how inflation and anti-inflationary monetary policy impacts the U.S. stock market and how policymakers should respond.

After the COVID-19 pandemic began, fears of catching COVID, rising unemployment, and other factors suppressed consumption. These negative demand shocks reduced inflation.

Several factors then revived inflation. Massive vaccinations beginning in December 2020 and the easing of lockdowns increased consumer confidence. President Biden’s $1.9 trillion of fiscal stimulus in March 2021 increased disposable income. Consumer spending soared beginning in the first quarter of 2021. Increased demand interacted with supply constraints arising from supply chain bottlenecks to raise inflation. Summers (2021), De Soyres et al. (2022), Di Giovanni et al (2023), and others presented evidence that expansionary fiscal policy after the pandemic played a major role in stoking U.S. inflation.

When the economy was on the cusp of reflating, the Federal Reserve in August 2020 announced a new monetary policy framework called Flexible Average Inflation Targeting (FAIT). FAIT implies that the Fed will react more aggressively when inflation falls below the 2% target than when it rises above target. The new framework also indicates that the Fed will react more aggressively to labor market shortfalls than to excess demand in the labor market.

This paper investigates when investors priced inflationary anticipations into asset prices and whether fiscal policy news influenced inflationary expectations. The results indicate that investors did not begin bidding down the prices of assets exposed to inflation until April 2021, when the consumer price index (CPI) inflation rate exceeded 4%. Thus as increased mobility after people were vaccinated and expansionary fiscal policy contributed to soaring consumer spending in the first quarter of 2021, investors remained complacent about the risks of inflation. Investors then depressed the prices of assets exposed to inflation in subsequent months as inflation rose. Results using daily fiscal news events indicate only a tenuous response of inflationary expectations to news of expansionary fiscal policy.

The results also indicate that there was little expectation that the Fed would tighten policy until November 2021, as the CPI inflation rate approached 7%. Markets then priced in tighter monetary policy on November 2021 and January, April, May, and June 2022. The evidence indicates that stocks that suffer from inflation fell on average by 9.2% per month over these months. After this, changing expectations about monetary policy caused massive swings in stock prices.

While investors and policymakers active in the 1970s and 1980s remember the devastation that inflation and disinflationary monetary policy can cause, most of those who are active now were lulled into complacency by decades of quiescent inflation. Investors did not react to news of expansionary fiscal policy, exploding consumer spending, and other factors stoking inflation. The Fed also did not react with anti-inflationary policy until inflation reached multi-decade highs. They then responded with what Eggertsson and Kohn. (2023) called an unprecedented tightening. This tightening first multiplied losses in the stock market and then stoked uncertainty and volatility. The Fed, rather than adopting an asymmetric framework that downplays inflation, should respond to both incipient inflation and to labor market shortfalls. This is all the more important as the incoming Trump administration adopts expansionary fiscal policies, tariffs, the repatriation of illegal immigrants, and other policies that can stoke inflation.

Source: U.S. Bureau of Labor Statistics