How Stock Markets Depend on Rate of Inflation

The rate of inflation is another important market mover. It is measured by the wholesale price index, the figures for which are published every week. The rate of inflation exercises a strong influence on the government’s monetary policy, i.e. whether the government should stimulate growth through increased liquidity, or restrain growth through tightening money supply. Increased liquidity is normally a bullish indicator for the stock markets whereas a tight money policy is a bearish signal.rnA sustained high rate of inflation is resulted in following situations:rnHigher inflation rate normally followed by high interest rates and high interest rates have an adverse impact on corporate profits in the long run because they increase the cost of bank loans, push up manufacturing costs and reduce the demand for final products. rnHigh interest rates adversely affect companies operating in the following industries: commercial vehicles, automobiles, consumer durables, tractors, farm equipment, construction and housing. This is because these industries flourish on abundant availability of cheap credit.rnA high rate of inflation also has other hidden implications. It pushes up the market value of assets owned by companies. rnThis creates higher entry barriers for new entrants and reduces competition for existing players. This is a bullish indicator. The bearish indicator is that it increases the replacement cost of old plants and machinery. Therefore, during periods of high inflation it pays to invest in the shares of companies which have a large, updated and modernized asset base.rnIt also pays to invest in companies operating at full capacity utilization because it is easier for them to raise the prices of their final products than to raise their production levels. Raising the volume of production normally requires additional investments.rnInflation also affects our ability to compete in world markets. A high rate of inflation pushes up the manufacturing costs of exporters and reduces their profit margins. In order to retain our export markets the government is then usually compelled to -go in for a devaluation of the rupee in relation to the U.S. dollar and other major international currencies.rnA high rate of inflation also tends to shift investible funds from financial assets like bonds, company deposits, bank deposits and other fixed-interest investments to land, property, shares, gold, silver and commodities. A stable economic and price environment is the best of all possible worlds for the stock market. Purchasing power in real terms goes up, demand expands and companies make more profits and pay higher dividends. In a stable price environment, people tend to switch their investible funds from tangible assets to non tangible assets like shares and bonds. Though investments in shares tend to thrive in both high-inflationary and low-inflationary environments, on the whole a low-inflationary environment is better in the long run for equity investments.rnHigh inflation is a permanent feature of the economy and a never come to an end. This could not be farther from the truth. Inflation is a cyclical phenomenon — prolonged periods of high inflation are invariably followed by periods of low inflation, or sometimes, even deflation. This is a firm fact revealed by history. Inflation contains within it the seeds of deflation and vice versa. This is but another example of the dialectic working in a non-linear world.