Inflation Vs. Government Vs. Stock Price?
Inflation and government play a significant role in stock price changes. Thus, it’s vital to understand how they are related.
What is inflation?
Inflation measures the rate at which prices for goods and services rise in your everyday life.
Have you ever noticed the stuff you bought from the store a year ago has increased the price? The answer to this changing phenomenon is simple – Inflation!
Inflation is the rise in the price of general goods and services. Why do prices rise?
Inflation occurs due to several reasons:
- Increased demand: The fundamental reason for inflation is a rise in demand. If the demand for particular good increases while the supply is unchanged, the prices of these items will rise, leading to inflation.For example: Suppose Russia decides to stop drilling for oil and gas. It will increase the prices because there will be a supply shortage in the market, and people will pay more for the available supply.
- Monetary policy: When the total expenditure made by the government exceeds the total receipts it collected in a fiscal year, the federal reserve prints more currency to meet the deficit. Due to the printing of currency, the money supply in the economy increases, and people have more “money in hand.” This causes inflation.
- Increase in production cost: When there is a rise in the cost of raw materials or wage demand by laborers, the business increases the selling price of goods. Ultimately, consumers have to bear the high cost. This also leads to inflation in the economy.
Is Inflation Good or Bad?
Inflation can have both positive and negative impacts on an economy.
A moderate inflation level can help stimulate economic growth by encouraging spending and investment. In USA and Canada government is trying to keep the inflation rate around 2%.
High inflation can erode the purchasing power of money, reduce consumer confidence, and lead to economic instability. For example, Venezuela’s hyperinflation.
How does inflation impact stocks?
Inflation impacts the stock market in the following ways:
- Affects company earnings: The rise in inflation means the price of the product and services offered by any company will increase. This price rise is passed on to final customers. Due to this, customers would buy fewer products or avoid them if the goods are not need-based. This affects the revenue and earnings of the company. Since earnings are a vital factor of fundamental analysis, investors would not choose to invest in companies whose earnings are low.
- Increase in interest payments: Any increase in inflation would push the government to reduce the liquidity in the economy. This would lead to a rise in repo rates, increasing the interest rate of bank loans.
Let’s understand this with an example.
Imagine a company XYZ has taken on a loan of $10 million at a variable interest rate of 5% per year for five years. It means the company has to pay $500,000 in interest payments each year for the next five years. Due to inflation, the interest rate changes, and now the new increase rate is 10%. In this case, their interest payments will rise to 1 million.
It will drastically impact company profitability, and stock prices can decrease.
How government policies impact stock price?
Indirectly, government policies can significantly impact stock price, as they can influence various factors that affect the performance of individual companies and the overall economy.
Government is the financial guardian of the economy. Thus, its decisions play a significant role in the functioning of the stock market. Following are some ways through which it can impact the stock market:
- Increase in interest rates: Any rise in interest rates reduces the cash in hand of people. This affects the spending habit of people. When the government raises interest rates, it can decrease borrowing and spending, negatively impacting companies’ earnings and stock prices.
- Quantitative Easing (decreasing interest rate): It is a policy to stimulate economic growth. Central bank increase liquidity which encourages lending and investment. It is usually done when economic growth is very slow. It’s to boost, but on the negative side, it can cause inflation. For instance, in 2021, during the COVID period, the stock prices of all companies increased due to the government’s massive money printing and the record-low interest rates.
- Government Regulations: If the government bans any product or alleges any company for fraud or mispricing, the company’s products are no longer supported by customers’ and investors’ trust. This also eventually leads to a fall in the company’s earnings and share prices.
Key Takeaway
- Always remember more liquidity means more demand. With more demand, the price of assets will rise.
- Low-interest rates can boost the stock market.
- High-interest rate is like gravity for the stock market.
Note: The impact of government policies on stock prices can take time to materialize and can be affected by various other factors, including global economic conditions and investor sentiment.
Inflation and government play a significant role in stock price changes. Thus, it’s vital to understand how they are related.
What is inflation?
Inflation measures the rate at which prices for goods and services rise in your everyday life.
Have you ever noticed the stuff you bought from the store a year ago has increased the price? The answer to this changing phenomenon is simple – Inflation!
Inflation is the rise in the price of general goods and services. Why do prices rise?
Inflation occurs due to several reasons:
- Increased demand: The fundamental reason for inflation is a rise in demand. If the demand for particular good increases while the supply is unchanged, the prices of these items will rise, leading to inflation.For example: Suppose Russia decides to stop drilling for oil and gas. It will increase the prices because there will be a supply shortage in the market, and people will pay more for the available supply.
- Monetary policy: When the total expenditure made by the government exceeds the total receipts it collected in a fiscal year, the federal reserve prints more currency to meet the deficit. Due to the printing of currency, the money supply in the economy increases, and people have more “money in hand.” This causes inflation.
- Increase in production cost: When there is a rise in the cost of raw materials or wage demand by laborers, the business increases the selling price of goods. Ultimately, consumers have to bear the high cost. This also leads to inflation in the economy.
Is Inflation Good or Bad?
Inflation can have both positive and negative impacts on an economy.
A moderate inflation level can help stimulate economic growth by encouraging spending and investment. In USA and Canada government is trying to keep the inflation rate around 2%.
High inflation can erode the purchasing power of money, reduce consumer confidence, and lead to economic instability. For example, Venezuela’s hyperinflation.
How does inflation impact stocks?
Inflation impacts the stock market in the following ways:
- Affects company earnings: The rise in inflation means the price of the product and services offered by any company will increase. This price rise is passed on to final customers. Due to this, customers would buy fewer products or avoid them if the goods are not need-based. This affects the revenue and earnings of the company. Since earnings are a vital factor of fundamental analysis, investors would not choose to invest in companies whose earnings are low.
- Increase in interest payments: Any increase in inflation would push the government to reduce the liquidity in the economy. This would lead to a rise in repo rates, increasing the interest rate of bank loans.
Let’s understand this with an example.
Imagine a company XYZ has taken on a loan of $10 million at a variable interest rate of 5% per year for five years. It means the company has to pay $500,000 in interest payments each year for the next five years. Due to inflation, the interest rate changes, and now the new increase rate is 10%. In this case, their interest payments will rise to 1 million.
It will drastically impact company profitability, and stock prices can decrease.
How government policies impact stock price?
Indirectly, government policies can significantly impact stock price, as they can influence various factors that affect the performance of individual companies and the overall economy.
Government is the financial guardian of the economy. Thus, its decisions play a significant role in the functioning of the stock market. Following are some ways through which it can impact the stock market:
- Increase in interest rates: Any rise in interest rates reduces the cash in hand of people. This affects the spending habit of people. When the government raises interest rates, it can decrease borrowing and spending, negatively impacting companies’ earnings and stock prices.
- Quantitative Easing (decreasing interest rate): It is a policy to stimulate economic growth. Central bank increase liquidity which encourages lending and investment. It is usually done when economic growth is very slow. It’s to boost, but on the negative side, it can cause inflation. For instance, in 2021, during the COVID period, the stock prices of all companies increased due to the government’s massive money printing and the record-low interest rates.
- Government Regulations: If the government bans any product or alleges any company for fraud or mispricing, the company’s products are no longer supported by customers’ and investors’ trust. This also eventually leads to a fall in the company’s earnings and share prices.
Key Takeaway
- Always remember more liquidity means more demand. With more demand, the price of assets will rise.
- Low-interest rates can boost the stock market.
- High-interest rate is like gravity for the stock market.
Note: The impact of government policies on stock prices can take time to materialize and can be affected by various other factors, including global economic conditions and investor sentiment.