Inflation as a Driver of Financial Market Prices

Victor Levinson Comments

Since the financial media continues to stress the importance of inflation on financial market prices, we will once again discuss this topic (the most recent previous coverage was in April 2021).

Inflation refers to a situation in an economy where prices in general are rising. When this occurs, the impact is that the same amount of money buys less, also referred to as a reduction in purchasing power. It is important to note that the price increases that constitute inflation are for the same goods and services; price increases due to improvements in quality or efficiency or productivity of what is being purchased are not considered inflation. An example of this is the modern day electronics-loaded automobile compared to its many predecessors.

Another significant feature of inflation is that it does not affect all people/businesses in similar ways. Some businesses may be able to charge higher prices for their goods and services, adding to their profits, while others may have to pay more for their inputs and labor, thereby reducing profits. People on fixed incomes, or those whose incomes don’t rise to keep pace with the price increases, can end up with materially reduced purchasing power, sometimes having to choose among basic necessities. For those with money to invest, inflation is often accompanied by rising interest rates. While rising rates can lead to bond price declines for some period, as time passes these rising interest rates generate additional income for investors. The relationship between inflation and stock prices has been mixed.

There can be different driving forces for inflation in different time frames. One factor is increased demand for the goods and services being produced/provided in the economy. This would normally be a good sign for an economy, as an expanding economy provides funds for business innovation and research, additional tax revenue for government to support groups that need additional assistance, and new jobs and an improved standard of living for many in the workforce. Another inflation driver is a shortage of supply, which causes/allows producers and service providers to increase prices. These types of price increase are often unfavorable to the economy, as they can make prices too high for people/businesses to pay. When this kind of inflation occurs, the US Federal Reserve (Fed) often steps in to raise the interest rates it controls in order to slow down/cool off the economy. Excessive tightening by the Fed can lead to prematurely interfering with a favorable expansion of the economy. Excessive tightening also is likely to lower bond prices, at least in the short run (see above), and may adversely affect stock prices, which typically benefit from low interest rates, as stocks and bonds compete for investor money. (NOTE: The Fed announced in December that it plans to raise interest rates in 2022, but we will hold off on writing about these changes until early next year.)

The inflation the US is currently experiencing appears to be of the unfavorable variety, characterized by supply shortages of important products and services, and labor shortages, as potential workers either pass on returning to the labor market or demand higher wages to do the same work. These kinds of factors driving prices higher with no improvement in quality are moving the Fed towards an earlier-than-anticipated tightening of interest rates, albeit at still very low levels. This tightening would be designed to slow down the economy and its current excessive, unfavorable inflation.

We expect that inflation will continue be a topic of great interest to the financial markets, and accordingly plan to keep you updated on this subject as we head into 2022.