Inflation | A Stake Original Series: Part 2
In part 1 we looked at exactly what inflation was and how we may measure it. With that understanding, let’s apply some of our newfound knowledge. How do we control inflation and what effect does it have on the stock market?
The Economist’s Toolbelt
Some inflation is a good thing. Central banks generally target 2-3% every year. Rising prices allow for wages to increase and economic growth to happen. Too much inflation is a problem.
Let’s say The Fed releases their figures and inflation is revealed to have increased by a rampant 6%. Rising prices directly impact your money in two ways.
Firstly, goods and services are more expensive. It is unlikely that wages grow as quickly as inflation, and everyday living costs more.
Moreover, even if you choose to save, purchasing power decreases as the dollar is devalued. $100 can buy far less after prices have risen by 6%.
What can be done?
Historically, interest rate changes are the primary tool a central bank can use to influence the economy.
Interest rates are essentially the price of money. Of course, when you take a loan from the bank, an interest rate is charged (cost to borrow). When you have money in the bank, the bank will pay you interest.
The central bank will change the rate it charges banks to borrow from them (and other big banks), which flows through to all interest rates in an economy. For those interested, pun intended, the way that one rate change flows through is known as interest rate transmission. It’s both complex and interesting, read about it in-depth here.
So, if the rate increases, borrowing money becomes more expensive and saving money is more attractive. People are less likely to spend, and more likely to save.
High spending is one factor that leads to inflation. Increasing rates decreases spending, and should help decrease inflation.
Whether central banks have the flexibility to increase rates right now is another, more contentious and complex, question.
For most of the last decade, central banks have been trying to increase inflation! This is why we have seen massive cuts to interest rates worldwide in an effort to stimulate spending.
What does this mean for my portfolio?
In its most simple form, interest rates and the stock market have an inverse relationship in the short term. Higher interest rates, a consequence of increasing inflation, have a number of effects on stocks.
- There are more attractive, less risky investments away from stocks. As interest rates rise, the return on bonds and savings also increases. This moves money away from the stock market and into such options.
- Financing costs for businesses increase. Debt is more expensive both increasing the current costs of businesses and disincentivising them from borrowing to spur further growth.
- The economy can be expected to slow down decreasing company earning potential.
This explains why increased inflation can lead to some short term panic in the stock market.
That being said, inflation and the stock market have both increased over the long run. Remember… time in the market beats timing the market.
Now, having read the above you’d be forgiven for having more questions now than 5 minutes ago. This is a simplified version of a deeply complex financial system that is less predictable than has been made out. In Part 3 we will look at which stocks specifically perform best in a high inflation environment.