How Does Inflation Affect the Stock Market?

If you've bought a car or even eggs recently, you've likely noticed the persistent rise in prices. Over the past few years, inflation has been a significant issue, eroding consumer purchasing power.

However, there are signs that inflation may be slowing. How long will this trend last? What impact will it have on your investments? What is the Federal Reserve doing to combat high prices?

The answers to these questions are complex and involve several moving pieces and even more questions.

Does inflation affect the stock market?

Stocks have a complicated relationship with inflation. Generally, stocks should rise along with prices as companies are able to pass their increased costs along to consumers. That means higher inflation should lead to higher stock prices, at least in nominal terms.

That is not always the case though as when companies raise their prices consumers may not buy as many items as they previously had or may substitute less expensive items for high-priced ones. This can weigh on companies’ profits, which in turn can affect their stock’s valuation.

How has inflation impacted the market in 2024?

In April 2024, inflation showed some signs of easing but still remains much higher than the Federal Reserve's 2% inflation target. The Consumer Price Index (CPI) increased by 3.4% year-over-year, down from March's 3.5%. Core CPI, which excludes volatile food and energy prices, also slowed a bit, rising by 3.6% compared to 3.8% in March.

This slight cooling has had a noticeable impact on the market. Initially, bond yields dropped, but then reversed and climbed higher as traders absorbed the full report, which included a higher-than-expected core CPI number. This back-and-forth suggests that traders are still unsure about where inflation is headed. High interest rates are still making things tough for durable goods and housing costs, adding to the economic uncertainty.

Rate cut estimations are mixed. Some investors are now expecting the Federal Reserve to possibly cut rates in November, while some economists believe there will be no cut until March 2025, with inflation remaining stubbornly high. If inflation continues to slow, the Fed might ease up on rate hikes and could even consider cutting rates as inflation approaches their 2% target.

While there are some signs of inflation cooling, the mixed signals from the data and the volatile market reactions make it clear that predicting economic trends remains tricky.

Deflation vs disinflation: What's the difference?

Disinflation is the slowing down of inflation rates, meaning prices are still rising but at a reduced pace. For instance, if inflation drops from 5% to 3%, we experience disinflation. Conversely, deflation is an actual decrease in the overall price levels, leading to negative inflation rates. In deflation, prices fall, such as when inflation goes from 2% to -1%. While disinflation signals moderation in price growth, deflation can be concerning as it may cause consumers to delay spending, potentially stalling economic growth.

How do interest rates affect the stock market?

Investors must also consider the actions of the Federal Reserve. Part of the Fed’s mandate is to promote price stability.

When prices rise too fast, consumers have less purchasing power, which can impact their quality of life, lower their ability to save, and make it harder for them to budget. To combat rising prices, the Fed will often increase short-term interest rates.

As it becomes harder and more expensive to borrow money, consumers tend to spend less. That decrease in demand will eventually halt the rapid rise in the prices of goods and services. This sometimes can lead to a recession, which can be a negative for stocks.

What happens to the stock market when the Fed cuts or increases rates?

Higher interest rates can also raise the desirability of fixed income investments relative to equities. If investors are now getting an approximate 5% yield by purchasing certain new bonds, they may rebalance their overall portfolio weighing it more towards bonds than stocks. This means they may have to sell some of their stocks which can depress overall equity valuations.

Conversely, when the Fed cuts rates, borrowing becomes cheaper, which can boost corporate profits and consumer spending, generally leading to higher stock prices. Lower interest rates make bonds less attractive, which generally prompts some investors to shift their portfolios towards stocks, potentially increasing equity valuations.

Do interest rate hikes hurt the stock market?

Interest rate hikes can potentially have a negative impact on the stock market. When rates rise, borrowing costs increase for companies, leading to higher expenses and lower profits, which can drive stock prices down. Higher rates also make loans more expensive for consumers, reducing their spending power and, consequently, business revenues.

As interest rates climb, bonds become more attractive due to their higher returns with lower risk, causing some investors to shift from stocks to bonds, further pressuring stock prices. Higher rates can also potentially slow economic growth by reducing business investments and consumer spending.

Valuation adjustments also play a role. Increased rates raise the discount rate used to value stocks, lowering the present value of future earnings. However, the overall market impact depends on economic context and investor expectations. If hikes are seen as necessary by the Federal Reserve to combat inflation, the market may react less negatively or even positively. Unexpected or aggressive hikes, though, can cause significant volatility and declines.

Does the stock market keep up with inflation?

The stock market often keeps up with inflation over the long term, as companies can raise prices to offset higher costs, maintaining profit margins. Historically, equities have provided returns that outpace inflation, preserving investors' purchasing power.

However, in the short term, high inflation can cause volatility. Rising costs and interest rates can squeeze corporate profits and reduce investor confidence, leading to market downturns. While stocks can be a good hedge against inflation over time, they may not consistently keep up with inflation in the short term, and individual stock performance can vary widely based on the industry and economic conditions.

Can inflation cause a stock market crash?

When inflation rises rapidly, it erodes purchasing power, leading to higher costs for consumers and businesses. Central banks may respond by increasing interest rates to curb inflation, making borrowing more expensive and reducing household spending and business investments.

This can lead to lower corporate profits and investor confidence, triggering a sell-off in the stock market. Higher inflation may also decrease the real value of future earnings, making stocks less attractive compared to other investments.

However, it's important to remember that markets are resilient and have weathered such challenges before. Investors can adapt by diversifying their portfolios and focusing on sectors that tend to perform well during inflationary periods, such as commodities and real estate. Staying informed and making strategic adjustments can help navigate these economic shifts and potentially find new opportunities for growth.