Watch: What is inflation and why is it important?
Fears about runaway inflation have sparked a global sell-off in stock markets around the world, as investors worry that central banks may soon have to hike interest rates to curb runaway inflation.
Inflation is a key measures of economic health but — as economies bounce back from COVID-19 — it is an increasing worry for investors. There are fears that the unleashing of a years worth of pent-up consumer demand, combined with trillions in stimulus spending, could send prices soaring.
Inflation is a Goldilocks measure — too low, and economies stagnate; too high, and growth slows. It can be steered by the policies of central banks and most aim for a sweet spot of around 2%.
Most major economies are currently below that level but it is not expected to stay that way. Commodity prices have already started soaring, which will eventually filter through into prices of goods on shelves. Everyone from car manufacturers to tech companies have also been hit by a shortage of microchips caused by an unexpectedly large surge in demand.
Read more: Global markets sell off on inflation fears
If inflation gets out of control, it can cause headaches for companies and, in turn, their shareholders. People find goods more expensive and therefore can't buy as much. Sales suffer and profits fall.
Investors determine the value of a company based on future profit forecasts, which filter through to shareholders through buybacks, dividends, or share price increases. The higher inflation goes, the less shareholders can buy with profit gains. Shares therefore become less valuable.
Runaway price rises could also force central banks to increase interest rates — another thing that would be bad for share prices.
"We’re at a point of major readjustment following an unprecedented economic shock and this is fuelling concerns that rising inflation will trigger central banks to tighten monetary policy which will hit asset prices," said Nigel Green, chief executive of deVere Group.
In simple terms, inflation refers to the rate of rising prices: the higher the rate of inflation, the less bang for your buck. Inflation not only affects costs to the consumer, but companies too. The rising price of raw materials — for example copper or iron ore — pushes up costs.
Inflationary pressures are particularly acute right now due to recent rounds of stimulus spending in the trillions in the US, which are meant to drive recovery and growth. The worry is it may not actually help things much and instead simply drive up prices — a measure analysts have called a "perfect storm".
"Ultimately it goes back to the question asked by the great Paul Tudor Jones about a year ago: can the Fed suck all this money back out of the system as quickly as it injected it," says Neil Wilson, chief market analyst for Markets.com. "The answer then was almost certainly no, and post the recent policy shift and vast pro-cyclical stimulus it is clearly absolutely no."
Central banks try to control inflation through interest rates. Generally, if inflation rises above 2%, monetary policy committees increase interest rates to encourage saving rather than spending.
"All things being equal higher inflation implies higher interest rates, and higher interest rates are particularly toxic for companies that promise little in the way of profits today, but rapid growth in the years to come," said Nick Hyett, equity analyst at Hargreaves Lansdown. "That’s a pretty accurate description of many tech stocks, and the US market is increasingly dominated by US tech names."
If rates rise, this can have a knock on effect on things like credit cards and mortgages with a variable rate. This in turn, means people have less money to spend. Companies therefore bring in less and profits continue to be under pressure.
Rate rises could also make the interest on corporate debt piles stacked up during COVID seem insurmountable.
"Despite the market jitters investors shouldn’t be abandoning the tech sector just yet," Hyett said. "This time last year the oil price had just plummeted into negative territory for the first time ever, and that alone means costs are going to be higher now than they were a year ago, in turn driving goods prices higher.
"A temporary boost in inflation was inevitable. What matters is whether inflationary pressure is sustained – there’s no convincing evidence that’s the case yet.”
The US Federal Reserve recently signalled a willingness to let the economy run hot — above 2% — to ensure the inflation is sustainably meeting target.