How does inflation affect financial markets?

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Rebecca Cattlin
By :  ,  Former Senior Financial Writer

What is inflation?

Inflation is the overall rise in the price levels of an economy over a set period, resulting in reducing the purchasing power of a currency. Simply put, when price levels rise, each currency unit buys fewer services and goods.

As a currency loses value, prices rise, and consumers buy fewer goods and services. This loss of purchasing power affects the general cost of living for the public, meaning people have to spend more to put petrol in their car, buy groceries or get a haircut.

A certain amount of inflation is generally accepted in the economy. And in fact, higher inflation can encourage short-term spending as consumers buy goods before prices rise quickly. But savers eventually see the value of their savings erode, reducing their ability to spend or invest. As consumers tighten their belts, it leads to a reduction in economic growth.

What causes inflation?

Inflation is caused by either high levels of demand – which happens when the economy grows too fast – or supply-side factors that boost the cost of goods and services.

Demand-pull inflation tends to arise when employment levels are high, and wages are increasing. As consumers start to feel more confident in their disposable income, they buy more products and services. If demand increases faster than supply, then prices rise quickly. This isn’t necessarily a problem over the short term, but if the imbalance continues, the result is that inflation spikes beyond normal levels.  

Companies can exasperate the situation by raising prices too. If they know that there is high demand, and that consumers can afford more, they can hike up prices.

Cost-pull inflation occurs when the supply of goods and services increases due to production costs. The demand for the products remains unchanged, but there is a shortage in supply due to problems in the production line.

Producers have to find ways to cover additional expenses, such as expensive raw materials or rising transport costs. Unfortunately, these are normally passed on to consumers.

Signs of cost-pull inflation include increasing commodity prices, wage increases, changes in government fiscal policy and central bank monetary policy.

Learn more about supply and demand in financial markets

Is inflation good or bad?

Inflation can be good or bad, depending on the circumstances. As consumers, we tend to fear rising inflation, because it raises the cost of living. But moderate inflation drives economic growth, which increases employment rates and causes wages to rise. Workers with higher wages can buy more, and this virtuous cycle keeps the economy growing.

However, if inflation is too high or too low, a damaging economic cycle can appear. If left unchecked, inflation could spike, and unemployment can increase as economic growth slows. Stagflation is the term used to describe the combination of high inflation and unemployment.

Governments and central banks try to maintain a set level of inflation that finds this balance. For example, both the Federal Reserve and Bank of England aim to maintain a rate of 2% inflation.

How to measure inflation

The standard measure of inflation is the inflation rate, the annualised percentage change in a general price index. The most common price index is the consumer price index, or CPI.  

What is the inflation rate?

The inflation rate measures the increase or decrease of inflation over a period, ordinarily year-on-year. Central banks will use the inflation figures they receive from statistics agencies to set interest rates and manage the money supply in their economy.

Discover how interest rates impact financial markets.

The metric is also used by many government departments to inform pay rises and welfare benefits for retirees.

The main inflation number can obscure crucial details and large month-to-month swings in various goods and services, so agencies who compile inflation statistics weigh the impact of multiple goods and services based on our usage.

Policymakers often focus on core inflation by excluding certain goods and services, such as food and energy prices, because they can be volatile.

Learn about other macroeconomic indicators.

What is the CPI?

The consumer price index (CPI) indicates when goods and services bought by households rise or fall in price. It is the most widely used measure of inflation.

The CPI is essentially a massive shopping basket containing many of the most popular goods and services bought by households. As the prices of the items change over time, so does the basket’s total cost.

The ONS gives a percentage weighting to the items in their basket. For example, housing and household services occupy 32.8% of the basket, transport 10.7% and alcohol and tobacco 3.5%.

The contents of the basket will change to mirror changing consumer buying habits. For example, in April 2021, 17 items were added to the CPI basket – including electric and hybrid cars, hand gel, men’s loungewear bottoms and smartwatches – and 10 items were removed.

There are unique CPIs for each country or economic bloc.

For example, the US Bureau of Labor Statistics (BLS) produces a CPI by surveying 23,000 businesses and monitoring the prices of 80,000 consumer items.

The UK’s Office for National Statistics uses similar surveys and formulas to establish the CPI figure. Around 180,000 separate price quotations are currently collected every month by the ONS to compile its indices, covering over 720 representative consumer goods and services. In addition, around 300,000 quotes get used measuring owner occupiers’ housing costs each month.

Discover how the CPI impacts forex.

How is inflation controlled?

Inflation is controlled by central banks and governments, which use a variety of methods to increase or decrease the rate of economic growth. Three of the main tools are:

  • Monetary policy: when interest rates are hiked, it reduces demand in the economy and should lower inflation. When interest rates are low, on the hand, consumers are more likely to spend money and inflation rises
  • Fiscal policy: increasing taxes can reduce consumer spending, lower demand and reduce the overall levels of inflation
  • Monetary supply: when money supply increases faster than production output, it means there is more money trying to buy the same amount of goods. This imbalance between demand and supply can drive up prices. Maintaining a steady monetary supply is key to preventing runaway inflation

Inflation and the stock market

Reports of rising inflation can affect stock markets, especially if the inflation figure is outside of the targets set by a central bank or if inflation suddenly spikes. Investors and business owners often fear high inflation because it can lead to rising interest rates and a cut in demand.

When this happens, company earnings can be affected and dividends might get reduced, which can cause share prices to decline.

Any increase in interest rates by a central bank pushes up borrowing costs, and the lower demand for goods and services will hurt growth in company revenues. Sentiment for specific stocks, sectors and the stock market as a whole will be affected.

An increase in interest rates to lessen the impact of higher inflation causes investors to focus on other potentially high-yielding investments, such as bonds, commodities or forex. These investments are considered less risky during inflationary periods.

When inflation is falling, central banks can lower interest rates to stimulate the economy by adding liquidity to markets. The lower interest rates also encourage investors to take their funds from high-interest rate yielding securities like bonds.

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Inflation and exchange rates

Inflation reports are considered high-impact news releases on any FX trader’s economic calendar. News of rising and falling inflation in an economy can have a dramatic and immediate impact on the value of a currency versus its peers.

A rise in interest rates is good for the value of a domestic currency because it encourages foreign investment inflows. The more demand for the local currency, the more its value rises.

For example, suppose core inflation is rising rapidly in the US economy. FX traders and investors might believe the Federal Reserve has the capacity and motivation to raise interest rates to ensure the US economy doesn’t overheat. The US dollar should rise if traders and investors think an interest rate is on the cards.

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Commodity prices and inflation

Historically, commodity prices have a positive correlation with inflation – the higher inflation, the higher the cost of raw materials and the higher the price of final goods consumers will pay. This is why precious metals, oil and gas, and agricultural products are often the cornerstone of any diversification strategy or hedge against inflation.

Commodity prices have also been used as a leading indicator of an inflationary environment. The theory goes that the effects of economic shocks are felt by the producers and manufacturers first, and by the time the high prices trickle down to consumers, inflation has its hold on the economy.

However, the relationship isn’t always that straightforward, especially in recent years. Over the last 10 years, the correlation between major commodities and consumer price indices has been negative. Rising commodity prices have been met with falling inflation rates. This is because most manufacturers take on the price increases themselves to keep their sales stable. So, real commodity prices are more volatile than consumer-facing costs.

Commodity prices are also dependent on a host of other factors that have little to do with inflation. For example, a stronger dollar in the global market will make commodities more expensive in foreign currencies, and then there are unique factors such as mining accidents, natural disasters and weather cycles.

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Bonds and inflation

Inflation tends to have a negative effect on bonds, as it results in higher interest rates, which makes the payments from fixed-income assets less desirable than new, higher-yielding assets.

Short-term bonds may see less movement, but longer-term bonds will have inflation risk priced in because the higher the expectations of future rates of inflation, the more income investors will demand. We tend to see investors swapping out of longer-term bonds and into short-term bonds when inflation rises.

However, bonds can prove resilient. We’ve seen this already in 2022, as although inflation fears are rising, central banks continue to buy bonds to support their economies’ quantitative easing programmes.

Another crucial relationship to point out is that between bonds and stock markets. Bonds tend to show more stability in times of market stress, and have an inverse relationship with share prices. This is where their reputation as somewhat of a safe-haven asset comes in. Although bonds are sensitive to inflation, they can provide a hedge against movements in share prices.

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