Inflation: characteristics and its bond with the stock market.
As the Nobel Prize winner Milton Friedman once said: "Inflation is taxation without legislation".
Inflation is the general increase in prices of a wide variety of goods and services through time. Of course, some products' and services' prices fall while others' rise, but when there is an overall increase, the value of money decreases.
For example, if you forgot 1$ in a pocket of your pair of jeans in 2000, that same dollar would have far less value now in 2023 than it had when you left it there. In fact, you would need 1.75$ today to buy almost the same things that you could have bought with 1$ in 2000.
According to the Bureau of Labor Statistics consumer price index in the USA, prices are up 74.70% since 2000, or 2.46% on an annual basis. To present it the other way round, that one dollar could buy only the 57.14% value of things and services today than it could have bought in 2000.
Why do we let a thing called inflation eat out our money's value over time ?
The reasoning behind inflation's importance lies in the Time Value of Money (TMV). According to TMV's concept the same amount of money is worth more today than it will be in the future, and is based on the assumption that every rational human prefers to take the same amount of money now than get it later. Most of us (if not all of us) would prefer to take 1000$ now than take 1000$ in 5 years, because during that period we could have used this money to invest it, use it to cover our needs or even save it for an unexpected financial disaster. In essence, we would have chosen to take that 1000$ now because otherwise we would have lost many opportunities.
And here comes another financial term which is the Opportunity Cost (OC). OC is the cost/loss of value a person accepts when choosing one option instead of the alternatives. Let's say I decide to invest 100$ in the stock market. The tech company I invested this money in scored a 15% upside earning me 15$, but on the other hand the energy company that I avoided striked a 30% upside. If I have invested in the energy company instead of the tech one, I would have earned 15$ more, and that's my Opportunity Cost. I hope next time I will do better.
How is inflation measured ?
Inflation can be measured by various ways but the most commonly used are two of them.
Among the two, the Consumer Price Index (CPI) is the most well-known. CPI in the USA is calculated by the Bureau of Labor Statistics, and in other countries by respective responsible public authorities, by measuring the changes in prices out of a basket of products and services that the average consumer buys. That means that the price of bread, milk, electricity and rent are of higher value to the index than luxury cars or cigars. It is also important to mention that there are other subcategories of CPI such as Core CPI (excluding high volatile goods and services), CPI-E for the elderly (represents better the elderly consuming habits) etc.
If in year X the CPI is 1000$ and in year X+1 the CPI increased to 1100$, that means that there is a 10% inflation rate.
The second way of inflation measurement is by using the Producer Price Index (PPI), which calculates the changes in average prices that domestic producers earn by selling goods and services. Once again like the CPI, PPI belongs to a family of Indices and the measurement of inflation is based on the changes of its value.
Deflation
Deflation is the exact opposite of inflation. It's when money loses its value as time passed. On the surface the idea that with the same money we can buy even more things in future seems ideal, but in reality deflation is a red flag for an economy and usually represents a recession. In economies we want the money to always be in motion in order to help the economy grow. Deflation suggests a stationary economy where there are less and less investments and transactions, which therefore lead to a GDP decrease.
So what do we want then ???
Most economists agree that low digits positive inflation suggests a healthy economic environment, where people and businesses are encouraged to invest and grow while not losing their purchasing power. In general, an inflation rate between 0%-3% is considered enough to sustain economic growth.
High inflation and how to tackle it.
As for deflation, very high inflation figures are also a bad sign for an economy, because consumers don't have enough disposable financial resources to cover their needs and "wants".
To combat high inflation rates countries adjust their Monetary Policies by changes the interest rates and thus controlling the amount of money in the economy. By rapidly increasing interest rates, borrowing becomes more expensive, the economy slows down, the amount of money that exists in the economy becomes stationary and the inflation decreases.
A matching example for this is the financial consequences of the Covid-19 outbreak. During the pandemic, despite the slowdown of the production and service provisions in almost every sector, governments around the world printed more money through their Central Banks to help their citizens survive the crisis. This emergency reaction , though, had its own consequences. A huge amount of money was poured into the global economy without it being justified by any real economic growth. This led to an important inflation rate increase, reaching 8.7% and 8.75% in the USA and Globally, respectively. Following this inflation rate spike, governments are now increasing their interest rates in order to stop it.
Inflation and the Stock Market: a strong bond
As it was stated before, in most of the times, higher inflation is followed by higher interest rates. Of course not every company in the stock market is the same, but higher interest rates make borrowing even harder and more expensive to achieve. During these periods, high growth companies that are not well-established yet or even non-profitable struggle to survive. There are many examples of very promising companies that failed because they couldn't get access to further funding.
On the other hand there are types of corporations that can benefit from inflation rises such as retail stores that expect to increase their revenues, and financial institutions and banks that are earning more due to higher interest rates.
The investors are also affected. If an investor wants a 6% Return on Investment (ROI) and the inflation rate is 2%, then he targets for an 8% increase to his capital. If in that same period, inflation rises to 5% the investor will get a net 3% Return on Investment.
However, despite the type of company or investor, what the stock market is afraid of is the unexpected inflation increases and decreases. The market is reasonable in the long term, but it gets really volatile and irrational in the short term, when rapid unexpected changes happen.