Why is Inflation a Four-Letter Word for the Markets?

And why are the Central Banks all around the world desperate to control it?

Inflation is well understood in India… we call it “mehngaai” in Hindi. Simply put, our monthly budget is not enough to buy us the same amount of goods as last year or last month.

A litre of milk, a kilo of potato, a bag of rice, a couple of dozen mangoes, and of course lemons & melons are staples but are going out of reach for the middle class.

Retail inflation in India printed at 7.8%, an 8-year high, not a surprise with the astronomical petrol and diesel prices. Inflation is high all over the world, in the US it is at a 40-year high. The textbook definition of inflation is a rise in prices as too much money chasing too few goods.

Let me illustrate with an example.

On a primitive coastal island with 25 inhabitants, they used exotic seashells as currency. There were 1000 seashells on the island and these were exchanged for food, clothing, firewood, etc. Life was smooth, prices were stable. A large storm brought with it 1000 more of these seashells which the locals quickly snapped up.

Now everyone was wealthier so wanted more goods. Before the storm, the price of 10 coconuts was 1 seashell. Now people were willing to pay 2 seashells for 10 coconuts. Zoom. Prices went up… just like that… as money in the pockets of the locals doubled but the number of goods remained the same.

Too much money chasing too little goods causes inflation.

One would say what is wrong with inflation? It will ultimately benefit the person who is the seller of the goods. Well, governments believe that some inflation is good. It will spur growth by deterring savings and encouraging consumption. In India’s case, the central bank targets an inflation rate of 4% with a margin of going above or below 2%. Beyond that, they have to find ways to manage inflation. If it shoots up they maneuver the economy with strategies comparable to a General of an Army.

But why?

Price stability is the highest goal of central banks. High inflation is like a tax. Mostly on the poor, as it hits them very hard. Central banks believe and rightly so that out-of-control price is a nightmare that should be avoided at all costs. Once the inflation genie is out of the bottle and spirals out of control it is very hard to stem it. Countries like Zimbabwe & Venezuela have been destroyed by hyperinflation. You can read about them here & here.

Persistent high inflation will fuel inflation expectations, wages will rise, goods will be hoarded, and manufactured goods prices will be raised as inputs prices go up which will, in turn, raise inflation .. A vicious circle, if there ever was.

Savers are punished as their money will fetch them fewer goods (value erosion), whereas asset holders rejoice as asset prices appreciate. Inflation in action.

How did inflation raise its ugly head after so many years?

There are many reasons, the biggest is the quantitative easing or printing of currency by the Central banks which is akin to the storm which bought in a lot of money in the earlier example.

In the aftermath of the pandemic and shutdown, the financial system went into a coma. To stabilise the economy, governments started buying assets (mainly bonds from the banks) to ensure that there was enough money in the system to buy goods and services. Trillions of dollars were poured into banks and interest rates were lowered so that banks would give out loans to support businesses and individuals.

Wealthy countries like the US transferred money to every citizen’s bank account so that they would be supported as there were massive job losses.

The pandemic may have passed and the crises averted but the money flew into buying more consumer goods (aka coconuts) and assets (homes, cryptos, stocks, etc.) instead of planting more trees i.e. production and farming.

The stock market crashed at first and boomed. Home prices, Cryptos, and risk assets showed massive appreciation. People were feeling rich. They were happy. They wanted to go out and buy stuff. Demand was strong and growing, but the production was hampered due to supply chain issues. Shortages were common. So supply did not keep up with demand. Prices started rising to satisfy the demand.

There was a belief that as soon as the pandemic cools off, supply chain issues will resolve and prices will stabilise. Unfortunately, Russia invaded Ukraine, and oil and gas prices shot up. Major boost to inflation as petrol prices affect everything. China locked down many cities again because of its zero covid policies. Europe was seriously limping because of its dependence on gas from Russia.

Inflation started raging.

How does the Central Bank manage inflation?

The biggest tool the Central bank has to control inflation is interest rates. They keep raising interest rates. Rates go up, it is more expensive to borrow, fewer companies will take out loans to expand, fewer consumers will borrow to spend, mortgage will be higher, demand will be lower, economy will cool off, and inflation will be stemmed. It is an indirect way to ease and slow the economy.

Another way is to sell bonds in the system, which reduces the money in the system, liquidity will go down, and less money will flow into the economy, killing demand mainly for financial assets.

Unfortunately, the side effect of raising interest rates is also its impact on Growth. The economy may stop growing and may decelerate.

The popular belief is that the Central Bank in the US & India underestimated the inflation problem and has been slow to raise rates. Stronger and faster steps may have to be taken, which may shock the system and put breaks on the economy.

All of this is OK, so why is it making the stock market nervous?

Fears of the “R” word – Recession (slow or negative growth for many consequent quarters) or Stagflation (high inflation and slow growth) is scaring the markets.

If the Central banks push countries into a recession by aggressive rate increases growth will take a beating. Profits will decline. Central Banks do not have an exact formula to raise rates just enough to control inflation and not hamper growth.

They will sacrifice growth to control runaway inflation.

The US has raised rates by half a percentage point and India also raised in a sudden and unscheduled manner by 0.4%.

Still, why are people selling their stocks?

The Stock Market is a complicated place. Here are some reasons why there would be a selloff.

• If rates rise, then bonds and fixed deposits will give higher returns, investors, therefore, may have an alternative. They may prefer to invest in safer, predictable instruments like bonds against stocks that have unpredictable and most likely lower earnings in the near future.
• The stock price of the company is the present value of the perceived future cash flow of the company. (Present value is how much the future rupee of earnings is worth today).  Higher rates mean the present value of the future cash flow is lower. This prompts them to sell their stocks. To know more about present value, click here.
• Price-earnings ratio is an important determinant of stock price.

PE Ratio = Stock Price/Earnings per Share.

A stock with a price of Rs10 a share and earnings per share last year of Rs1 a share would have a P/E ratio of 10. If the stock price were to go up to Rs12 a share, and the earnings were to stay the same, the stock’s P/E ratio would then be 12, and the stock would be relatively more expensive because you would then be paying a higher price per Rupee of earnings.

When interest rates go up & there is a fear of recession, the whole equation changes. The earnings may fall, and the sentiment will be depressed so the Price to earnings ratio may move lower. People are not willing to pay a lot for future earnings.

Click here to understand the PE ratio.

When there is uncertainty and confusion, there will be panic, buyers disappear and sellers double. The market gets nervous and runs amok.  Stocks that were darlings get dumped unceremoniously.

Stocks are getting sold for all of the above reasons and some.

In the next few months, the stock Markets will react violently higher or lower to every incoming data point, every statement or action by the Central Bank Governor or the Government.

Inflation is therefore the most important data point for this year through next year. If it cools off and the world has staved off a recession, things may look up again for the markets.

Until then grin and brace as your roller coaster ride is picking up speed. 🙂