Inflation is one of the key areas of interest in economics given the scale of its ability to affect the economy, both at scale and on the individual level. The term refers to the consistent increase in the prices of goods and services over time. The inflationary pressure building up in a country can be due to a host of factors, such as in the case of demand-pull inflation, where the price of goods are affected by increased demand, cost-push inflation, where businesses offload the increased cost of production onto the customer, or purely monetary-based, where the increased supply of money into the economy causes an imbalance that drives the prices of goods and services upwards. A country’s central or federal bank has a critical role in intervening to manage inflation on a country’s behalf to mitigate the effect inflation can have on economic development and growth. Inflation unchecked has the potential to have spillover effects into the global economy unless properly managed.
The impact of inflation on stock market performance and its widespread effects
The rising price of goods is costly for consumers, but the effects of inflation are not limited to them. Sustained inflation can set off a vicious cycle of increased prices and reduced purchasing power between consumers and businesses that has the power to affect the economy as a whole. The drop in consumer spending that increased prices necessitates for example, has the power to affect stock market performance, as it affects companies’ profitability. This can have a ripple effect in the economy as a whole. For example, if corporations were to put off recruitment-related expenses in order to better face the risk of market volatility, it would in turn affect standards of living for a great many people – while reduced efficiency would hurt the company’s in a rebound effect.
The direct impact of inflation on stock prices can vary on a case by case basis, often due to the steps taken by affected companies to mitigate its effects themselves. One key way to judge the effects of inflation on stock value is by identifying whether the stocks belong to the growth or value category. Growth stocks represent the equity of companies that are expected to show fast-growth. These are usually startups who expect to burn through a great deal of resources in the bid to establish their position in the market. This means that they may not necessarily be profitable in the face of volatility. In addition, growth stocks will also suffer due to increased interest rates, as the interest rate is used by governments to mitigate inflation. On the other hand, value stocks, which represent the equity value of mature companies, can prove to be a valuable investment in times of inflation as their value is expected to appreciate over time, irrespective of short-term fluctuations in the market.
Global companies often have a global pool of investors who will also be monitoring and responding to the inflationary pressures of the market that their investment is operating in. Sustained inflation can very well cause these investors to shift their focus from investing in growth stocks to value stocks to hedge the diminishing value of their wealth. If inflationary pressure does not let up according to forecasted models, falling investor confidence could even affect their willingness to invest in value stocks. This can prompt investors to shift their focus into less volatile markets, effectively causing the redistribution of wealth across industries or even countries. Residents of countries with high inflation will witness this phenomenon as foreign investors ‘pulling out’ from their country, at times even resulting in entire businesses uprooting themselves to shift elsewhere in order to protect their margins.
How high inflation rates affect individual wealth strategies
Understanding the behaviours of the individual is vital in understanding how their choices affect the economy in times of inflation.
Changes in consumer behaviour
Increased expenses will have most consumers reevaluating their expenses to identify where their priorities lie in distributing the reduced purchasing power they have among their needs. Even expenses such as groceries, housing, and healthcare, while essential, will likely be downsized in times of high inflation. Other non-essential expenses such as leisure, travel and the purchase of high value consumer goods will likely cease entirely except in the wealthiest demographics, which will have an impact on related industries. Depending on the severity of inflation, this will also affect industries such as international tourism as well, as tourists will naturally feel prompted to travel to destinations that offer them better value for money. Rising inflation in popular destinations will therefore provide opportunities for less popular ones to showcase the attractions they have to offer to the international market.
Diversification of investment portfolios
One other key area that will be directly affected by inflation are the investing habits of those affected. Most people will tend to direct their funds towards ‘safe’ investments such as treasury-backed investments, focusing more on taking a disciplined approach rather than chasing immediate returns. Fixed-income investments will also not appeal to the market in such an environment, as this income will be vulnerable to the effect of inflation, affecting the purchasing power of its income. The purchasing power of the principal too will be affected. Inflation-indexed securities will therefore be of particular appeal to the market.
Investing in property is also a traditional way of mitigating the effects of inflation through investment. Like value stocks, the value of property investments are expected to increase over the longer term, though values may fluctuate over the short term. Property investments also have the potential to offer passive income in the form of rental payments, which would be a welcome addition during difficult times. Property is also a very tangible asset, which can also be important in boosting investor confidence. Tangible assets are generally more attractive to investors during periods of high inflation, due to their low correlation to the value of other traditional assets. The market for commodity investments such as infrastructure and precious metals such as gold and platinum are also likely to grow during periods of high inflation. However, many investors attempting to invest in such commodities at the same time will drive up their prices as well, at which their resilience to inflation will also decrease.
Inflation can redistribute wealth from creditors to debtors
Rising inflation has the potential to redistribute wealth from creditors to debtors, be it individuals or nations. This is because high inflation reduces the value of liabilities as it does the value of assets. The terms on which the liabilities have been contracted upon however will likely include protective measures to ensure that creditors do not suffer unduly because of this, especially when it comes to lending between nations. However, it is important to bear in mind that borrowers have the potential to benefit from inflation as they would be paying back the nominal value of the loan they obtained, while its real value would have depreciated from when the loan was first obtained. Calculating the effect of inflation on wealth redistribution however can be very difficult, as it would depend on how the individual’s or country’s assets and liabilities are structured.
The uncertainty that inflation introduces into an economy can have ramifications that go beyond mere economic decision-making. Starting from consuming habits to investing habits, this uncertainty can cause ripple effects throughout, affecting the growth and the stability of the nation and even beyond. Understanding the nature of inflation as it happens therefore is important for consumers, investors, and policymakers alike in order to maintain stability and sustained and sustainable economic growth.
(Theruni Liyanage)