How Does Inflation Impact the Stock Market?

Most investors consider inflation as a negative element for the stock markets. It is considered to result in higher cost of living and resultant lower purchasing power. When inflation rises, people tend to earn less due to lower returns from investment. Higher inflation causes interest rates to rise, and this impacts the cost of equity. 

So is the impact of inflation on the stock markets always negative? Thanks to easily available data to the investor masses, people today also see the positive impact of inflation on stock market performance. To make informed investment decisions, let us have a look at the various aspects of inflation and how it impacts the stock markets.

Inflation explained in simple terms:

Inflation is a term used to refer to an economic situation that sees a general rise in prices of goods and services. It is measured in percentage terms to indicate average price changes over time in a basket of products and services. ‘

Watch this video to know more about Inflation:

How does inflation arise?

There are two main causes of inflation:

1. Demand-Pull

Under this, the demand for goods and services increases as compared to their supply within the economy. Due to this, there is a scarcity of goods and buyers may be willing to pay a higher price for them. This causes prices to rise, thereby resulting in inflation.

2. Cost-Push

In a Cost-Push condition, the cost of producing certain goods in the economy rises due to rise in the cost of raw materials, wages, etc.. This results in a decrease in supply. However, since the demand may remain unchanged, there can be an overall increase in prices and this results in inflation.

Effect of inflation on the stock market

Inflation can have a positive or negative impact on the stock markets, depending upon monetary policy decisions and investors’s ability to hedge. Here are some of the main effects of inflation generally observed in stock markets.

Reduction in purchasing power of investors:

When inflation in an economy rises, the present value of future cash flow reduces. As the value of money reduces, people can purchase a smaller quantity of products with the same amount of money. 

For instance, if the ongoing inflation rate is 5%, a receivable of Rs. 1,000 after one year will fetch a value of Rs. 950 today. If inflation rises to 10%, the receivable will be valued at Rs. 900 today.

This reduction in purchasing power tends to have a negative impact on stock markets, as investors will buy fewer stocks with the same amount of money.

Interest rates and valuations:

When inflation rises, the interest rates tend to go up as the central bank will increase interest rates on deposits and loans to control liquidity and thereby curb inflation. As loans or cost of capital rises, the projected cash flows of companies come down and result in a drop in equity valuations. 

Rising interest rates also mean a fall in bond prices, which in turn leads to capital losses for investors. 

Stock prices

Higher inflation can result in a speculative scenario around future stock prices and results in higher volatility in the stock markets. 

Stocks are broadly categorized into value and growth. While value stocks are backed by strong cash flows, growth stocks may have negligible cash flow. Therefore, as inflation rises and interest rates move up, growth stocks may be negatively impacted. On the other hand, value stocks and inflation are positively aligned and tend to move together.

Rising inflation has a negative impact on stocks that are income generating or pay dividends. This is because the dividends may not be enough to cover for rising inflation while taxation levels remain the same, which results in a double-negative effect.

Impact on index

As inflation rises, people have less spending capacity and may also have lesser savings. This causes stock market investments to go downhill since investors have lower cash holdings. Therefore, rising inflation results in an adverse impact on indexes such as the Nifty and Sensex.

However, at times, if the rise in the Inflation is steady, it can be considered good for the markets as it helps to stimulate economic growth.

Can inflation be controlled and how?

Whenever a country’s inflation rises to an extent that is uncontrollable, the government may step in to control the same through monetary policy changes. In cases where the prices are seen to be rising to high levels, the government may introduce a contractionary monetary policy to curb the economy’s money supply and thereby increase the cost of borrowing. This helps in decreasing the GDP and eventually in curbing inflation.

Contractionary monetary policy involves lower availability of credit in the market and higher interest rates. This promotes savings and rise in reserve requirements of the banks to restrict loans available to the public to reduce market liquidity.

Conclusion

Inflation should not be taken as the only determinant for investment decisions. Long-term investors must avoid panic buying or selling because of the fear of inflation, as it can eventually be controlled through various government measures. Stock market investments are best made after careful consideration of company fundamentals alongside technical analysis.

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