How does Inflation affect stock markets?

Inflation in general terms refers to the rise in the prices of goods and services in the economy over a period of time.

What is inflation?

Inflation in general terms refers to the rise in the prices of goods and services in the economy over a period of time. It indicates the loss of purchasing power of people in the economy due to expanded prices and unchanged earnings, the decline in corporate profits, the standard of living, etc.

There are mainly two causes of inflation:

1. Demand-pull inflation:

In demand-pull inflation, the demand for the goods and services available in the economy rises above their supply. Due to such a condition, the goods become scarce and the buyers are willing to pay much larger prices for the same commodities thus pushing up the prices.

2. Cost-push inflation:

In cost-push inflation, the cost of production of some important goods in economy increase by way of increase in the cost of raw materials, wages, etc., and this addition in cost of factors of production leads to decreasing in supply however the demand remains the same and therefore leads in an overall rise in price levels.

Effect of inflation on the stock market

The effect of inflation on the stock market can be positive or negative depending upon the country’s monetary policy and the ability of investors to hedge.

1. Impact on the purchasing power of investors:

In the case of an increase in the inflation rate in the economy, the present value of the money that we will receive in future reduces i.e. with the reduction in PV we are able to purchase less from the same amount as compared to earlier

2. Impact on interest rates and valuations:

As a result of an increase in the inflation rate, the interest rates also go up which results in a decrease in the value of bonds, equities, and debt.

When the inflation rate goes up the interest rates or the bond yields also goes up which leads to a decrease in bond prices. This fall in the prices of the bonds leads to capital losses for bondholders like banks and mutual funds. Therefore rising interest rates are normally negative for banks.
When inflation goes up and the interest rates also go up, the cost of capital will also go up. When the bond yields go up the cost of capital goes up and therefore the future cash flows of the company will be valued lower. We know that the valuation of equities is done by discounting future cash flows. When the rate of discounting goes up obviously equity valuations go down.

3. Impact on stocks

Unexpected inflation contains new informationabout future prices and thus creates greater volatility of stock movements which in turn correlates with higher inflation rates.

Stocks are usually categorized into value and growth, value stocks have strong cash flows whereas growth stocks have little or no cash flow. Growth stocks are negatively impacted at the time of an increase in interest rates that is that the time of high inflation. While the relationship between value stocks and inflation is positive

The effect of inflation on stocks that pay dividends or income-generating stocks is negative. Since rising inflation makes them less attractive because the dividends are not enough to cope up with the inflation levels and also the taxation levels stay constant which causes a double-negative effect.

4. Impact on Sensex and Nifty

Since with the rising inflation, people have less to spend and have lesser savings because of rising prices. The investments in the stock market also go downhill because the investors have fewer cash holdings. Therefore, rising inflation creates an adverse on the Nifty and Sensex market and vis-à-vis.

However, at times rise in the inflation levels is also considered good sometimes as it helps in stimulating growth in countries. At the same time, it affects corporate profits because of higher costs of production and operation.

How can inflation be controlled?

In situations when the inflation rate in the economy increases to a level where it cannot be controlled by market forces the government steps in and implements policies to curb the inflation rates.

Thus, in cases where the prices are too high, the government forces a contractionary monetary policy wherein it tries to decrease the money supply in the economy in order to increase the cost of borrowing which in turn leads to a decrease in GDP and curbs inflation.

The implementation of contractionary monetary policy means lesser credits available in the market, increase in interest rates to promote saving and increase in reserve requirements of the banks by the RBI in order to restrict the loans given to the public and reduce liquidity and also reduction in the money supply in the economy by way of calling off debts by the government or asking public deposits.