What is the relation between inflation, stock prices, and gold prices?

The recent pandemic gave many shockers to the economy of every major country in the world. Most economies saw an unprecedented rise in inflation as well as gold prices. At the same time, stock markets in the majority of the countries crashed with all all-time high margins and eroded billions in investors’ wealth. Now that the markets all around the world have majorly recovered and gold prices also have more or less stabilized, the one factor that is still a major cause of concern for the world overall is the rising inflation. We have often heard that Inflation has a huge impact on the stock market of a country as well as the price of gold. Also, any fluctuation in the stock prices or gold prices has a direct impact on the other. 

This highlights that there is a direct relationship between the three and together (along with many other factors) they shape the economy of any country. Given below is a brief discussion that shows the relationship between inflation stock prices and gold prices that can help investors make sound investment decisions and financial planning. 

What is inflation?

We hear the word inflation on a daily basis on endless debates on the television and also face a direct impact of the same on our every need. This includes the rising cost of daily essentials as well as the other commodities that are often beyond the reach of the average Indian. So what exactly is this inflation and how does it increase the cost of everything? To put it in simple words, inflation is the reduction in the value or the purchasing power of money over time. It is also referred to as the increase in the cost of living in any country. Inflation is the result of many micro and macro factors like the pressure of the demand and supply of products in the country, the consumer expectations, cost-push inflation, the purchasing power of the citizens of the country, money supply, and liquidity policy of the central bank of the country, etc.  

How do inflation impact stock prices and gold?

Now that we have learned the basic meaning of the term inflation, let us understand its impact on the stock prices and the gold prices. 

1. Impact of inflation on gold prices

Gold is considered to be one of the safest forms of investment, especially in a country like India where gold is traditionally favored over other investment options. Gold has seen a tremendous increase in prices, especially on account of the pandemic. The pandemic resulted in huge uncertainty in the stock markets and resulted in heavy crashes in markets across the world. This prompted the investors to start investing in gold to safeguard themselves from the heavy losses of the stock markets. 

Gold and inflation have a direct relationship which means that whenever there is a rise in inflation, it results in a reduced value of the Rupee which in turn increases the prices of gold. As demonstrated in the recent past, when the inflation in the country increased, it resulted in increased demand for the yellow metal pushing its prices to the higher band. Now that the government has taken many measures to control the rising inflation, we have seen a decline in gold prices in the past month. 

2. Impact of inflation on stock prices

To understand the impact of inflation on stock prices there is no definite rule like in the case of its impact on gold. Investors have to analyze the impact of inflation in stock in the short run as well as in the long run. 

In the short run, the impact of inflation is more or less direct. This means that with the increase in inflation, the stock prices see an immediate fall and vice-versa. Higher inflation will result in reduced purchasing power which will directly impact investment in shares. The revenues of the companies will also be impacted on account of the higher cost of inputs and reduced demand. This has an overall impact of a reduction in share prices which can be ultimately attributed to higher inflation.

It is also difficult to generate higher returns for the investors in the short term if the inflation of the country is higher. Often in such cases, the real return is negligible or negative. In short term, higher inflation often leads to increased market volatility providing the traders with a window of short selling or buying according to the market conditions. 

In the long term, it is a common understanding that the stock markets more or less stabilize, and history shows that the markets and equities have shown better performance. Companies that have a sound business model and stable products are bound to generate good returns despite higher inflation and eventually grow in the long term. When the inflation is a result of higher cost-push inflation, the increased duration allows the businesses to stabilize and adjust to such high costs eventually pushing them to the ultimate consumers. This results in normalizing their profit rates and ultimately increasing their revenues. 

What is the relationship between stock prices and gold?

After learning about the impact of inflation on gold and stock prices, let us now understand the relationship between gold and stock prices. It is observed over the decades that stocks and gold are perceived to have an inverse relationship. This implies that whenever the stock markets fall, the gold prices see a boost and vice versa. Gold is often seen to perform better in a bearish market as it is considered to be a safer bet in the face of extreme market volatility. Investors today have better investment options rather than investing in traditional forms of gold luke gold jewelry or gold bars and coins. Today investors can invest in Sovereign Gold Bonds, Gold ETFs, etc., and eliminate the demerits of investing in physical gold. 

Conclusion

Inflation is present in every country in the world and the current inflation levels are high across the globe. Inflation eats away at the real returns generated through stock markets (especially in the short term) and also results in pushing the gold prices on the higher side. In such scenarios, investors move away from stocks toward stable investments like gold to minimize their risks. Such an increase in demand for gold further escalates the risk in stock investments resulting in declining stock prices. 

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