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Investors are spooked by rising inflation. Here’s what that means

Jessica Yun
·6-min read
People walk past the New York Stock Exchange (NYSE) at Wall Street on February 17, 2021 in New York City. - Wall Street stocks retreated early Wednesday as worries about potentially higher inflation accompanied much better-than-expected US retail sales. (Photo by Angela Weiss / AFP) (Photo by ANGELA WEISS/AFP via Getty Images)
Wall Street investors have been worried about rising inflation and US Treasury bond yields. (Photo by ANGELA WEISS/AFP via Getty Images)

If you follow the stock market closely, you might have seen that Wall Street wobbled its way through most of this week.

There was one key thing that global investors were concerned about: rising inflation.

This was coupled with other big movements; commodity prices rising to eight-year highs, and 10-year US Treasury yields reaching its highest level of 1.45 per cent since February 2020.

Here’s why fears of rising inflation have unsettled the stock market this week – and why it’s actually not all bad news.

What is inflation?

In simple terms, inflation refers to the general rise in prices in an economy over a period of time.

There are a few factors that can push up inflation: a rise in wages, interest rates, public spending, commodity prices, or in some cases hoarding or genuine shortages, among other factors.

A strong, growing economy can also cause inflation. Here’s more of a breakdown on where inflation’s at in Australia.

So what’s happened?

A number of these factors are happening at once, lifting inflation forecasts.

1. Global economic recovery is going well

For one, the global economy’s recovery from the pandemic-induced recession is picking up pace. Economic growth tends to push up inflation, because people have more money to spend, driving up demand for goods. But firms might not be able to keep up with demand, driving prices higher amid lower supply.

A better economy also means higher employment, pushing up wages – which leads to inflation.

2. Biden’s US$1.9 trillion bill proposal

The Biden administration also means the American economy is getting pumped with money. The new US President wants to have its US $1.9 trillion COVID-19 relief bill passed by the end of the week.

But many economists think that this relief package is “too big”, with former US Treasury Secretary Larry Summers believing it could “overheat” the economy and spark excessive inflation.

Summers thinks it would “set off inflationary pressures of a kind we have not seen in a generation, with consequences for the dollar and financial stability”.

Bear in mind that Biden’s proposal comes on top of the US$3 trillion in financial aid that Washington has already approved roughly since the beginning of the pandemic.

3. Commodity prices have risen

Commodities are the raw materials needed in the production of goods. So when the cost of these materials rise, then the price of those goods naturally increase.

Bloomberg’s Commodity Spot Index tracks the price movements of 23 raw materials – and this has risen more than 34 per cent in the last 12 months.

Last week, BHP CEO Mike Henry said he sees strong demand for commodities in the medium-to-long term.

So what’s the big deal if inflation rises?

When inflation rises beyond a comfortable level, there’s a key ‘lever’ that can be pulled to contain it: higher interest rates.

Higher interest rates means it’s more expensive to borrow money, discouraging businesses and consumers from spending.

(This is also why the Reserve Bank of Australia, and other central banks around the world, brought interest rates way down during the pandemic – to boost the economy by encouraging spending.)

The thing is, a low interest rate environment has been the status quo for quite a while now.

“Almost everything about today’s financial landscape is premised on central banks keeping interest rates low for a long time,” The Economist wrote in a recent piece titled Inflategate.

“Cheap money lies behind the idea that the government can spend however much it likes - including, say, on Biden’s planned infrastructure bill - and underpins today’s sky-high stock market values and abundant credit

“An abrupt change in the interest-rate outlook would be painful, as it was in 2013 when the Fed’s hawkish comments led to what became known as the “taper tantrum”.

“On Wall Street higher rates would be a shock. In emerging markets they would be agonising.”

Higher levels of inflation, especially if it’s unexpected or sudden, also spell bad news for stock market investors because it means higher input costs of a company – that is, what it costs the company to produce a good or service.

This might stem hiring and impact corporate profits, subsequently bringing the stock price of a company down.

What’s all this about rising US Treasury bond yields?

In just the space of roughly five months, the price of US Treasury bond yields have risen by more than 70 per cent, S&P Global reported last week. As bond yields rise, stocks become less attractive to investors.

"The higher the yield on bonds, the more we see this push to move out of stocks," said North Carolina-based managing partner of Cornerstone Wealth, Jeffrey Carbone.

"The market is starting to get a bit frothy, so investors are taking some gains off the growth areas of stocks, which had the biggest movements and moving it to more conservative areas for higher yields in the bond market."

But the market gets unsettled not just because of the rise itself, but because of its pace, JonesTrading chief market strategist Michael O’Rourke explains.

“If it is stable and steady, it is easier for equities to digest,” O'Rourke said, as reported in S&P Global. “A quick spike has the potential to create a shock.”

Bottom line: Do we need to be worried about rising inflation or not?

Three Australian economists told Yahoo Finance that they aren’t fazed by rising inflation – in fact, quite the opposite.

“Rising inflation could be signalling good economic times and rising margins for businesses. This is good news,” said independent economist and Market Economics managing director Stephen Koukoulas.

This sentiment was echoed by Kerry Craig, JP Morgan Asset Management’s global market strategist.

“Inflation can be a welcome sign that an economy is humming. Rising prices can help boost consumer demand and consumption and make it easier to repay debts,” he told Yahoo Finance.

He acknowledged that inflation was “a risk” – but said there are a few reasons why it won’t race out of control.

First of all, the US unemployment rate is recovering at a “fairly gradual” pace, which should have a dampening effect on inflation.

Secondly, the US Federal Reserve wants the economy to “run hot for some time” to make sure inflation levels are sustainable before adjusting interest rates.

“The nascent sparks of inflation we’ve seen recently and the corresponding sell-off in bond prices really reflects increasing positivity around the economic outlook,” Craig said. “Investors will need to keep an eye on inflation, but the signs right now suggest this won’t be a runaway risk.”

BetaShares chief economist David Bassanese also doesn't think we'll see high inflation in the long-term.

“I see any pull back in markets due to short-run inflation fears. However, as a buying opportunity, as it still seem likely that any inflation pick-up will prove fairly short-lived.”

If nothing else, the RBA’s own inflation target has been set at 2-3 per cent.

But we’re way below target: its latest figures reveal that inflation is currently at 0.9 per cent.

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