One of the topics making financial headlines currently is the re-emergence of inflation and what it might mean for the stock market and wider economy.
There are concerns that the combination of pent-up demand and fiscal stimulus will cause inflation to spike, prompting interest rate rises to prevent inflation from spiralling out of control. Higher interest rates are generally bad news for the stock market, as they make borrowing more expensive for companies and can shrink their bottom line as well due to consumers having less disposable cash to spend because of higher mortgage and credit card rates. This cycle of events is predicated on inflation rising to high levels and staying there. However, this is unlikely, and as a result, the stock market could be relatively unaffected.
The low inflation puzzle
Persistent low inflation, especially after the financial crisis has puzzled economists.
As the economy reached full employment (or very close to), some economists expected inflation to rise, as it has in the past — economists refer to the Phillips curve, which showed a positive correlation between low unemployment and higher inflation during the 20th Century. However, that phenomenon never really materialised during the years after the 2008 crisis and inflation largely remained below the Bank of England’s target of 2 percent.
The years since the financial crisis highlighted how the relationship between low unemployment and higher inflation weakened, and there has been numerous theories to help understand this. One example of this is the rise and fast-evolving nature of technology. Specifically, how the introduction and rapid advance of new technologies has exerted downward pressure on older, traditional goods. Not only has technology made large swathes of traditional products obsolete, it has also made information infinitely more accessible. The rise of e-commerce has now made it possible for customers to easily compare prices and find the best bargain, which may have started a race to the bottom. Recognising that customers can easily go elsewhere, firms are forced to keep their prices low.
The advance of technology has not only created new goods, it has also created new services. Post pandemic and as the economy begins to return to ‘normal’, this is a unique situation so runaway inflation is still unlikely. This is primarily because these inflationary pressures are one-time effects e.g. a family looking to finally take that holiday will probably only do so once, likewise, the massive fiscal stimulus will only be spent once. Because these are only one-time expenditures, the effects will most likely be short-lived.
The forces driving up inflation in recent months appear to amount to a sugar high. The technological disruption and the forces exerting downward pressure on prices are here to stay. In fact, the pandemic has only accelerated the adoption of these disruptive technologies, which may even have a bigger, downward effect on inflation over the longer term.
'Sugar high' forces
Low inflation could also be good news for the stock market, as it will allow central banks to maintain an expansionary monetary policy for longer, making it attractive for companies to borrow and invest. This scenario isn’t set in stone and we will have to wait and see how it all plays out but the factors driving inflation today appear to be temporary, and as a result, so may any spike.
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