An ideal scenario for the stock market is taking shape as the economy looks set to keep growing without lifting inflation

• The economy can still grow without driving inflation, and that would be an ideal scenario for the stock market.
• Market veteran Ed Yardeni said productivity gains are starting to materialize in a good sign for the economy.
• "Productivity boosts real wages, profit margins, and keeps a lid on prices."

The latest economic data suggests a type of Goldilocks scenario is about to play out in both the economy and stock market.

The key ingredient is productivity, which jumped 4.7% in the third quarter to mark the biggest increase since 2009, excluding 2020 when the pandemic created whiplash.

"It confirms our view that strong economic growth isn't inflationary if it is driven by productivity growth," market veteran Ed Yardeni said in a note.

Productivity, in which companies and their employees get more efficient, is important because it could keep the economy growing without driving prices higher.

And if inflation remains steady, it would give the Federal Reserve ample breathing room when it comes to its interest rate decisions. 

"Our analysis suggests that they [the Fed] should allow productivity-led growth to flourish because it is the main driver of prosperity while also containing inflation. Productivity boosts real wages, profit margins, and keeps a lid on prices. Productivity is the economy's elixir of life!" Yardeni said.

A scenario in which the economy keeps growing while inflation stays contained close to the Fed's long-term 2% target would be a type of nirvana for stock market investors, as it would mean the Fed could ultimately loosen its grip on interest rates and even consider interest rate cuts. 

And if the Fed is cutting interest rates because growth is steady and inflation has been tamed — not because an ailing economy needs stimulus — then stock prices should continue to move higher.

"We think the economy started a productivity growth boom in early 2016 that was interrupted by the pandemic. Now, it is likely to be accelerated by the aftereffects of the pandemic," Yardeni said, adding that if that happens, "the current decade might turn out to be the 'Roaring 2020's' after all."

Wharton professor Jeremy Siegel offered a similar view recently, saying that technological advancements like artificial intelligence will help boost productivity in the economy. And that should ultimately lead to higher profits and higher stock prices.

"I think the promise of AI is real. This year, our growth is being driven by productivity... productivity driven growth brings inflation down, it's good for earnings, but it does drive yields up. Higher real growth, more borrowing, more capital investment, I want to be in stocks and not bonds," Siegel said.

For evidence of a surge in productivity growth, he pointed to the fact that job hirings have slowed this year compared to last year, but GDP growth has surged.

"This year we are hiring at less than half the pace and we have two to three times the level of GDP growth. Why is that? One of the biggest bounce-backs in productivity I have ever seen," Siegel said.