Inflation and Its Impact on Economy & Stock Market

Watsala Shakya

Inflation plays a huge part in shaping an economy. The impacts of inflation can be both beneficial and detrimental to economy, to some inflation result in economic recoveries while in other, it becomes the reason economies need recovery. The increase in the price of electricity, fuel, food, housing, clothing and other commodities in the entire economy is known as inflation. Inflation is tied to the living cost, interest rates for borrowing, purchasing power of a currency and all the factors of the whole economy, this ultimately hampers the economy by retarding the economic growth of a country.

In simpler words, with Rs. 100, an average Nepalese in the 1980s could go to the market purchase a medium size cooking pot and 5 stainless steel plates in Kathmandu. At present, the price of a single stainless steel plate amounts to Rs. 250. The difference between what the Nepalese rupees could purchase in the past and now shows exactly what inflation does, it weakens the currency which actively demonstrates that a single unit of the currency would purchases lesser commodities in comparison to the past.

Inflation increases the cost of living and increases money supply in the economy. It becomes detrimental to the economy when the nation’s money supply surpasses the country’s economic growth.

Impact of Inflation on the Economy

A moderate rate of inflation is necessary in an economy to drive consumption which circulates cash and resources in the economy. High level of spending is often seen to be better, as they result in more consumption. As consumption of commodities increase, demand for them follows. To satisfy and meet demands of the market, the economy innovates and improves, which then gives rise to its economic growth.

In some economic situations where speeding is less, most of the income is saved, at this point of time a phenomenon known as the “paradox of thrift” comes into play. The Great Depression of 1929 is a great remainder of the phenomenon. During this time, savings from income rose while expenditure tightened, hence consumption decreased. This led to reduced demands in attempts to raise the falling demands for commodities, prices of all commodities in the economy were reduced resulting in a phenomenon completely opposite from inflation, known as deflation.

Inflation on the other hand when the levels are high could be a good stimulator for job growth, as inflation encourages innovation. Therefore, more job opportunities could be created. Although this sound great, the actual results seem much bleaker. With falling purchasing power, real income fall as well, which subsequently reduces the standard of living, especially to those with fixed incomes.

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When inflation pushes the prices of commodities upwards, people are forced to spend more. This injects money into the economy as to curb the rapid supply of money, demand rises. This may lead to further rise in inflation rates. This also means investments increase with consumption.  Corporations are also impacted by high inflation, the particular reason for the circumstance being higher input cost translates to lower corporate profit.

Investors may choose to buy gold and other precious metals when inflation rises, however the volatility of these assets can cancel out the benefits from price rises, especially in the short term. In order to curb inflation, authorities that is, the Central Bank, often turn to using interest rates. The authorities can either raise or reduce the cost of borrowing to stimulate the economy. In a situation where inflation rates and interest rate are low, the cost of borrowing money for investments or consumption becomes low. This can be seen as an appropriate to purchase homes, automobiles and other huge purchase. On the other hand, when interest rates and inflation are high, the time is seen to be ripe to invest in stocks and appreciable assets such as land and precious metals.

Impact of Inflation on the Stock Market

Inflation is perceived differently based on different investment options. Deflation increases the power if savings bases equity financing. This to investors make companies with little debt and large cash reserves more attractive. This encourages raising yield and increasing investment returns on securities.

On the other hand, in an economy with increasing inflation rates, investors in real state or stocks benefit as it raises the prices of their assets. This allows these assets to be valued at a higher selling price. However, the mode of investment may adversely affect investors. For those who possess cash to invest, inflation can be detrimental as value of cash weakens. Investors can protect their portfolio from inflation through inflation-hedged assets such as gold, commodities and real estate.

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Inflation encourages speculation, through risky business projects and stocks of companies which sets the notion that higher risks often translate to higher returns. This encourages spending instead of saving to some extent, if purchasing power of money is to fall it be better to invest. Investor may see inflation as a factor affecting stock prices, but it is important to filter through the various confusion surrounding the inflation and stocks. When observing performances of stocks during periods of high inflation, stocks mostly seem to do better. However, studies have pointed out that expected inflation impacts stocks positively or negatively based on the investor’s ability to hedge. In this, the government’s monetary policy plays a huge role in determining the ability to positively or negatively control inflation.

It has been seen that unexpected inflation showed being a strong positive correlation to stock returns during economic contractions. This actively demonstrates that the timing of the economic cycle is vital for investors to assess the impact on stock returns. In simpler words, unexpected inflation and stock returns are directly proportionate which signifies that both variables move in the same direction. Unexpected inflation is thought to bring current information regarding future prices which brings about volatility in the stock market. In other words, the higher the inflation rates, the greater the volatility of stock movements. Emerging economies are especially likely to face volatility of stock than those of developed stock markets.

Usually, interest rates are raised to curb inflation. Higher interest rates are hence associated with high inflation. This phenomenon acts positively in valuating stocks while it negatively impacts growth of stocks. Investor must be careful though. If they overestimate future growth the stocks may be overvalued which ultimately hinders growth.

When it comes to income generation from stocks in the form of dividend, the impact of high inflation makes it undesirable. Although inflation rates increase, dividends don’t. When inflation acts alongside declining purchasing power and taxation on earnings from dividend it leaves investors the bare minimum.

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