Effects of Inflation on the Stock Market

As per the latest trends, the inflation in India has slightly eased out, with the annual retail inflation rate being 4.83% in April 2024, down from 4.85% in the previous month. Investors must note that inflation significantly impacts the share market by affecting company profits, consumer spending, and investor behaviour. Through this article, we will understand the meaning of inflation and learn how inflation affects the stock market in detail.

How does inflation work?

To better understand how inflation affects the stock market, let us first begin with what is inflation and how it works in an economy.

Inflation, by definition, is a rate. It shows the speed at which the general prices for goods and services increase. This surge decreases the purchasing power of money. In other words, when inflation occurs, you need more money to buy the same things you could buy for less money before. For example:

• Say a loaf of bread cost Rs. 10 in 2023
• Assume that the inflation rate is 10% p.a.
• Now, in 2024, you will have to pay Rs. 11 (Rs. 10 + 10%) to purchase the same loaf of bread

What are the causes of inflation?

Inflation usually occurs in an economy due to two primary reasons:

Reason I: Demand-Pull Inflation

• This type of inflation occurs when the overall demand for goods and services in the economy rises, but the supply stays constant.

• For example:

  • Say there is a new mobile phone in the market

  • Everyone wants to buy it

  • However, there aren’t enough mobiles to satisfy the demand of everyone

  • This causes the price of the mobile phone to increase

• Similarly,

  • When everyone starts spending more money and keeps buying

  • The general prices of goods and services increase

  • That is because businesses can't keep up with the high demand

Reason II: Cost-Push Inflation

• Cost-push inflation occurs when:

  • The cost to produce goods and services increases
    and

  • Businesses pass those higher costs on to consumers

• For example,

  • Say the price of oil goes up

  • Now, it becomes more expensive to produce and transport goods

  • Consequently, companies facing these higher costs increase their prices

  • They do so to maintain their profit margins

How is inflation measured?

As stated earlier, inflation is a rate. This rate is usually measured in two primary indices:

• Consumer Price Index (CPI)

and

• Wholesale Price Index (WPI)

Let us understand them in detail:

What is the Consumer Price Index (CPI)?

The consumer price index measures the average price changes over time for a specific set of goods and services (often called a “basket”) purchased by urban consumers. This basket includes things like:

• Food
• Clothing
• Rent
• Healthcare
• Housing
• Fuel
• Light
• Other services like healthcare and education

The CPI is a common way to track inflation. That is because it reflects the spending habits of typical households. For example:

• Say the CPI rises by 3% in a year
• This means that the average price of this “basket” of goods and services has increased by 3%

What is the Wholesale Price Index (WPI)?

The WPI measures the average change in the price of goods at the wholesale level before they reach the retail market. It includes three main categories:

• Primary articles (like agricultural products)
• Fuel and power (such as coal, petroleum, and electricity)
• Manufactured products

For example:

• Say the WPI increases by 5%
• This increase shows that the average price of goods at the wholesale level has risen by 5%

How does inflation impact the stock market?

Having understood the meaning, measurement, and causes of inflation, now, we will study how inflation affects the stock market in different ways:

Impact on company profits and costs

• Inflation increases the costs for:

  • Raw materials

  • Labour, and

  • Other inputs

• Companies that cannot pass these costs onto consumers see their profit margins shrink

• Such companies often face:

  • Reduced profit margins

• Thus, investors must analyse which companies can maintain profitability during inflationary periods

• Usually, companies with “strong pricing power” perform well during inflation

Impact on consumer spending

• Inflation erodes the purchasing power of consumers

• This leads to decreased spending on non-essential goods and services

• Under inflationary conditions, it has been observed that:

  • The share price of companies in discretionary sectors (like luxury goods and entertainment) decreases

  • While the share price of companies operating in essential sectors (like consumer staples) remains stable or even increases

Effect on interest rates

• It is pertinent to note that the Reserve Bank of India (RBI) increases interest rates to combat high inflation

• These higher interest rates:

• Increase borrowing costs for companies and consumers
  • Increase borrowing costs for companies and consumers
    and
    
  • Reduce stock prices, especially of highly leveraged companies that rely on borrowing

• Furthermore, higher interest rates make bonds more attractive relative to stocks

• As a result, investors shift their portfolios from stocks to bonds, seeking safer returns

• This again impacts the share market by reducing the demand for stock

• Reduce stock prices, especially of highly leveraged companies that rely on borrowing

Changes in investor behaviour

• During inflationary times, investors shift their portfolios towards assets that are considered good hedges against inflation, such as:

  • Real estate

  • Gold and silver

  • Inflation-protected securities

• This shift impacts stock prices

• Consequently, inflation-resistant sectors (like energy and consumer staples) see more demand while others decline

Also read: Market capitalisation

What are the long-term vs. short-term impacts of inflation on the stock market?

Aspects	Short-term impact	Long-term impact
Explanation	In the short run, inflation causes: Market volatility and Usually, investors see rapid changes in stock prices based on inflation news and interest rate announcements   Uncertainty	Historically, stocks have provided protection against inflation over the long term That’s because companies adjust prices and earnings They try to keep up with inflation
Stock prices	Short-term volatility leads to sharp price swings These fluctuations present both risks and opportunities for investors	Over the long run, stock prices increase in line with inflation This commonly happens when companies grow revenues and profits

Conclusion

Inflation is the speed at which the general level of prices for goods and services change every year. Two primary causes of inflation—demand-pull and cost-push—are measured via indices, namely the consumer price index and wholesale price index.

Understanding how inflation affects the stock market is crucial for investors. Inflation affects company profits, consumer spending, and investor behaviour. During inflationary times, companies with strong pricing power thrive while others struggle with rising costs. Also, inflation erodes consumer purchasing power and makes bonds more attractive. This leads to shifting investments away from stocks and reducing stock prices.

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