Inflation is on everyone’s lips these days. But it hadn’t been for a while, so there’s nothing strange if you don’t know the exact meaning of the word. Everyone here who’s younger than fifty, for example, will probably have spent their whole adult life without inflation being such a big issue, considering that at least since the early nineties it hadn’t been a problem in most European countries. But now things have changed, big time.
The good news is that if you’re not exactly sure what all this fuss is about, you’ve come to the right place: let’s find out together why inflation is making investors so nervous!
Let’s start from the basics: what is inflation?
To put it simply: inflation is just prices going up. For example, have you noticed that the price tags of all kinds of stuff tend to rise every year? From houses and cars to beer and ice cream. Now, if prices go up by 2%, economists say that the inflation rate is 2%.
I chose this 2% not by chance. That’s actually what most economists believe to be the ideal inflation rate. Because it means that the economy is healthy enough for people having money to buy stuff (that leads to an increase in prices). But at the same time the price climb is not so steep that the €20 you have in your pocket in the morning becomes worthless by the end of the day (as can really happen during a tough inflation crisis).
So inflation is not necessarily bad?
As we said earlier, a bit of inflation is actually considered necessary in a market economy. Otherwise we’ll have a so-called “deflation” (prices decreasing), that leads to all other sorts of issues.
The problem with inflation comes when it gets out of hand. And also when the rise in prices is not followed by a rise in wages. Because then people can no longer afford to pay for what they need. Say that new iPhone you like… or even food, when the inflation rate gets really high.
That may be unfortunate for people, but what about the markets?
Ok, I see where you’re going: if prices go up, companies should be earning more, right? Well, there are several issues that make it a bit more complicated than it seems.
First of all, this increase also affects raw materials, energy and everything else. So companies might charge more, but they’re spending more too.
Let’s look at oil, for example, on which you can trade CFDs with Stryk.
Oil prices have been at a pricey level all year with WTI trading between $80 and $130 per barrel. In particular, oil spiked in March due to the Russia/Ukraine war and was trading above $100 until July. Between July and November WTI has been trading between $80 and $100.
Always remember though, past performance isn’t always an indicator of future performance. Don’t forget that you can also try them out with a Demo Stryk account to see if CFD trading feels right for you.
There’s also the fact that when money is worth less, people will use it more carefully. Depending on how bad inflation is, one might decide against buying a new car, a new Netflix subscription or even just going out for a beer. This will lead to a fall in sales, profits and eventually stock prices.
In the worst case scenario you may have an even worse situation called “stagflation”: when prices keep going up while wages shrink and the economy collapses. And that’s clearly bad for everyone.
Is there a remedy?
Well, if I had a fool-proof fix for inflation I would be probably heading the European Central Bank right now… but there are a few things that most economists agree that can help tackle an inflation crisis. Unfortunately, they’re usually bad for the markets.
The biggest weapon that central banks have in their arsenal is the power to change the so-called “interest rates”. That means literally the cost of borrowing money. In other words, it represents how much money is worth. Because if you borrow 100 euros from a bank when the interest rate is 1%, you’ll have to pay back 101 euros. But when the interest rate is higher, you’ll have to give them back more than that. And that’s why in such cases they say that the money costs more.
So when inflation exceeds that 2% that we mentioned earlier (reducing the value of money in your bank account), central banks increase interest rates (which in turn increases the value of that money). So that in the end the two should balance themselves and keep prices steady.
Phew… but why then is everyone still worried?
An interest rate increase makes all borrowed money cost more. That means that your mortgage costs more, as does everything you pay for with your credit card, what you had planned on investing in the markets or what your company relied on for expanding its business.
The consequence is that you may not be able to pay up your mortgage to the bank, you may have to spend less, invest less in the markets and your company may postpone its expansion plans. In other words, companies will make less profit and the economy will shrink.
Plus, sometimes that won’t even be enough to stop inflation from rising. And that’s exactly the situation we’re currently in: despite several rate increases by the American Federal Reserve and the European Central Bank, consumer prices have just started slowing down their ascent (and they’re still going up, anyway).
In our next article we’ll try to understand what is causing the current inflation crisis and what could be in store for us in the near future. In the meantime keep your eyes open for any news on inflation and use what we just talked about to better understand how that could affect the markets.