How to invest in a high-inflation, high-interest-rate environment

The Federal Reserve has pushed interest rates to their highest level in two decades. The relevant investing question is not how high those will go, but where interest rates will settle once the Fed is done.

Chairman Jerome Powell is committed to bringing inflation down to 2%, but that’s no easy task. The Fed is negotiating stubborn, competing deflationary and inflationary forces.

COVID-era supply chain problems have been solved. China’s recovery is halting, factories are operating at less than full capacity and the yuan is down against the dollar. All of that should make importing from the Middle Kingdom cheaper.

Inflationary expectations, however, are hardening — the Conference Board, New York Federal Reserve Bank and University of Michigan surveys of one-year inflation expectations average about 4.3%.

That’s why home prices are rising again.

Mortgages above 6% are not high if homebuyers expect inflation to persist and have good reason to anticipate their incomes to keep rising too.

The sectors where the Fed should expect interest rates to slow are proving stubborn.

Home-building is picking up.

Automakers have rebounded from pandemic-era semiconductor shortages and are making cars and light trucks at their pre-COVID pace.

The Infrastructure Investment and Jobs Act, the CHIPS Act and the Inflation Reduction Act are instigating double-digit annual gains in medical, road and public works construction. Factory building was up 76% in May.

Labor and equipment shortages continue to plague service industries.

Auto repair shops can’t find enough technicians. The sale of electronic vehicles alongside gasoline-powered cars challenges suppliers to adequately stock a broadening range of replacement parts. Shortages abound.

Tourism is booming. Airlines are crammed and can’t find enough qualified pilots.

After rising sharply in 2022, restaurant reservations have receded only a percentage point or two as inflation bites consumer purchasing power.

Overall, labor markets may not be quite red hot as they were earlier this year, but they are tight enough. According to the Atlanta Fed, wages continue to rise about 5.6% a year.

Plenty of other places in the economy are slowing — witness the layoffs in Big Tech and finance and slowing sales of clothing and footwear. However, if we have a recession, it will be mild, or we may experience only a few quarters with gross domestic product advancing positively but at less than 1%.

Neither would likely be enough to pull inflation permanently down to 2%.

In the decade between the global financial crisis of 2007-2009 and COVID shutdowns, the consumer price index rose an average of 1.8% a year, and the overnight bank lending rate the Fed targets averaged 0.62% and never exceeded 2.5%. The rate on 30-year Freddie Mac mortgages averaged 4.1% and never exceeded 5.1%.

That was the golden era of globalization, when multinational enterprises and big retailers like Walmart concentrated sourcing on least-cost suppliers without regard to geopolitical, pandemic or other calamity risks.

Now decoupling and hardening of supply chains to cope with continuing tensions with Russia, the potential for rupture in U.S.-China relations, the expensive shift to carbon-free energy sources and mitigating climate change risks are pushing up costs.

Those portend inflation closer to 4% than 2%.If the economy manages to grow 2%, that translates into overnight lending rate closer to 6% than the rock-bottom levels of the 2010s.

If you want to buy a home, there is no time like the present. Prices could fall in cities people desperately want to flee, like San Francisco, but in most places, new and existing home prices will continue rising.

Mortgage rates will dip occasionally but stay elevated.

Interest on bonds should be decent but stocks historically have and will likely continue to outperform stocks by a wide margin. Especially, large-cap stocks like those in the S&P 500 as big firms tend to have more pricing power and can more easily pass along higher costs for labor and materials than smaller businesses.

If you want to go with the traditional conservative prescription of 40% bonds and 60% stocks, put aside some ready cash in a money market account. If you are in a high tax bracket, consider a fund that invests in near-dated state and local debt that virtually guarantees the value of your principle will not be affected by abrupt movements in interest rates — for example, the Vanguard Municipal Money Market Fund.

Put the rest of your 40% fixed income in staggered maturity Treasury securities — depending on the yields at the time and how long you can tie up your money. Those can be purchased at TreasuryDirect.com.

For the 60% equities, consider a low-fee index fund, such as the USAA, Fidelity or Vanguard S&P 500 funds.

If you can afford to tie up more of your money and are far from retirement age or otherwise needing the cash — for example, for college expenses — weigh more heavily into the stock funds.

• Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.