A direct correlation exists between inflation and stock prices. Theoretically, inflation should not affect stock prices because companies can simply raise their prices to make up for the increased cost to produce goods and services. In reality, companies competing globally cannot raise their prices for fear of losing business to competitors. These companies are negatively affected by inflation. Investors must understand the importance of inflation to stock prices to know the impact inflation will have on their investments.
Inflation negatively affects corporate profits. Stock prices are a direct reflection of corporate net earnings. Many businesses are not able to change their prices to reflect increased cost. Companies typically pass the rising cost of production to customers in several stages instead of all at once. While this process is taking place, companies must bear the increased cost to deliver products and services to consumers. Businesses are also hesitant to increase the price of goods and services out of fear of consumers’ reactions. If a competitor is offering similar prices at a lower cost, consumers will buy goods and services from the competitor. A loss of consumers will reduce corporate profits and negatively affect the value of the company’s stock.
Inflation often causes the government to restrict monetary policy. The Federal Reserve typically increases interest rates in an effort to control inflation. Increased interest rates make borrowing money more expensive, which decreases the amount of money circulating through the economy. When consumers have less money, they spend less money. A decrease in consumer spending negatively affects companies’ earnings, and consequently stock prices. Increased interest rates also affect business investments, which are critical to the long-term growth of a company.
Inflation can last for a short or long period of time. The uncertainty about inflation affects investor confidence. Some investors may choose to sell their shares if they believe inflation will stick around for the long-term. If too many investors sell their shares, it can cause stock prices to decline because supply is greater than demand. Investors who continue to invest in stocks require a higher rate of return because of the associated risk. To achieve higher returns, stock prices must decrease.
The effect of inflation on stock prices depends on the severity of inflation in the economy. The measurement of inflation can show the severity of inflation. Several methods exist to measure inflation, with the Consumer Price Index (CPI) serving as the most popular method. CPI calculates sample prices of goods commonly used in the economy. Others methods include the Producer Price Index, the Employment Cost Index, the Gross Domestic Product Deflator and the Bureau of Labor Statistics' International Price Program.