Most central banks watch the inflation rate with a hawk’s eye because general price increases erode the value of the currency. The banks control inflation, by raising interest rates during times of high inflation.
High-interest rates have a negative impact on growth and may raise unemployment. Without careful management, the economy may experience a recession. Stock markets tend to be more volatile during periods of high inflation. Unexpectedly high inflation can have a brutal effect on corporate profits as firms need time to adjust prices to cover input costs. So, what causes inflation?
Inflation Causes
Inflation refers to a general increase in prices and there are several causes.
- Increases in the cost of producing goods and services can cause inflation. Input costs include labour, land, capital, or materials.
- Demand that exceeds supply will lead to shortages and price increases. Demand-pull inflation occurs in an expanding economy with low unemployment and rising wages
- Bank or government actions through monetary of fiscal policies, like reducing taxes or interest rates
The Inflation Outlook For 2023
As 2022 drew to a close, global inflation had started to ease and was predicted to end the year at 8.9%. During 2022, global inflation peaked at levels not seen since the early 1980s. Most central banks responded by increasing interest rates several times over the course of the year. Inflation is expected to soften to 6.2% in 2023 as commodity prices settle, global supply chains recover, and demand weakens.
Still, as 2023 comes there are a host of uncertainties that threaten to further disrupt the global economy. Further supply chain disruptions, skill shortages and possible energy price increases could all put upward pressure on prices, fuelling inflation. The recent dollar strength has weighed on emerging economies, increasing the cost of imports. This, in turn, will drive inflation.
The combination of inflation and higher interest rates will throttle demand as consumers have less disposable income. Higher interest rates constrain borrowing, preventing many consumers from buying big-ticket items. Organizations and individuals will have less money to invest or save.
There seems to be a consensus that higher interest rates may cause a mild recession in Europe and the US. Still, there are those who disagree. If investors call it right, they could invest in undervalued stocks with excellent growth prospects.
Implications For Investors
Stock markets had a terrible year in 2022, the worst since 2008. The Nasdaq shed 33.1% and the S&P 500, 19.4% over the course of the year, ending three years of consistent growth. High inflation and hard-hitting interest rate increases flattened growth. War in Europe and pandemic uncertainties battered investor confidence.
Many investors expect the downward trend in stock markets to continue into the new year. Stocks should stage a recovery in the second half of 2023. The Federal Reserve has indicated that interest rate hikes are far from over. Even if they don’t increase the rates further, interest rates are unlikely to come down before the end of the year. After years of low interest, the Fed increased interest rates seven times in 2022 by a cumulative 4.25%. The bank will continue to raise interest for as long as inflation remains high.
Interest rate increases affect growth industries like tech companies disproportionately. They need investment to grow and prosper and returns are also low in the early growth years. Investors tend to move to so-called value stocks when the stock market is under pressure. These stocks appear to trade at lower prices compared to their apparent worth,
Lower Stock Prices May Offer Good Investment Prospects
Lower stock prices offer investors opportunities to buy undervalued stocks. Then, sit it out to grow their assets over the years that follow.
After years of running a destructive zero-Covid policy, China is dismantling these policies. A growing Chinese economy should drive global growth, improve supply chain flows and enhance investor confidence, improving investment prospects.
