Inflation is one of those economic concepts that seems straightforward at first glance—and one that I have written about before. However, I wanted to revisit the topic as inflation numbers seem to be making their way increasingly (kind of an inflation pun?) into today’s financial headlines.
Prices rise, purchasing power falls, and consumers notice the difference every time they visit the grocery store or renew their home insurance policy. Yet within the world of investing, inflation occupies a far more complicated role. It is not simply a measure of what things cost today. It is also a powerful influence on how investors think about the future, how businesses allocate capital, how the Federal Reserve sets monetary policy, and ultimately how equity markets are valued.
Before proceeding, it is important to acknowledge a limitation. This article is not intended to provide a comprehensive review of every way inflation affects financial markets. Entire textbooks have been written on that subject. Instead, the goal is to outline several important connections and provide a framework for how investors might think about inflation as one of many variables influencing investment outcomes. After all, we certainly think about inflation (projections mostly) quite a bit at East Franklin Capital.
At its most basic level, inflation measures the rate at which prices for goods and services increase over time. While modest inflation is generally considered a normal feature of a growing economy, excessive inflation can create uncertainty. Businesses may struggle to forecast costs, consumers may adjust spending habits, and investors may become less confident about future economic conditions. As uncertainty rises, markets often become more sensitive to economic data releases, particularly inflation reports. In short, the magnitude and direction of inflation have a significant impact on the U.S. economy and financial markets.
One reason inflation receives so much attention is because of its influence on the Federal Reserve. The Fed’s dual mandate is to pursue price stability and maximum sustainable employment. Inflation data, whether measured through the Consumer Price Index (CPI), the Personal Consumption Expenditures Index (PCE), or other indicators, helps policymakers determine whether monetary conditions should become more restrictive or more accommodative (in other words, whether to raise or lower the federal funds rate). When inflation appears elevated or is projected to remain above the Fed’s target, policymakers may decide to increase the federal funds rate or maintain higher interest rates for a longer period of time. Conversely, when inflation appears to be moderating (or even falling), the Fed may gain flexibility to reduce rates or adopt a less restrictive stance. Importantly, markets are often focused not only on current inflation but also on expectations for future inflation. Investors are constantly attempting to anticipate what the Fed might do next, sometimes months before any policy action actually occurs.
I have written previously about how (in my opinion) markets have become FAR too sensitive to Fed rate moves (which you can read about here). While that is a discussion for another day, it helps explain why inflation reports receive so much attention. This is where the relationship between inflation and equity markets becomes particularly interesting. Please allow me just a handful of sentences to be an investment nerd. Stock shares represent claims on future corporate earnings. The value investors assign to those future earnings (i.e. the price of the stock) depends partly on the discount rate used to bring those future cash flows back into today’s dollars. Higher interest rates generally increase discount rates, which can reduce the present value of future earnings. Okay, in practical terms, when investors expect higher rates, they often become less willing to pay premium valuations for future growth. This dynamic tends to affect different sectors in different ways. Growth-oriented companies, whose expected profits may lie further into the future, are often more sensitive to changes in interest rates. More mature businesses with stable cash flows may be less affected. Additionally, REITs and other capital-intensive businesses can be particularly sensitive to interest rates (think of highly leveraged businesses facing high borrowing costs). Of course, other sectors (think banks and certain financial services) may benefit from those same rate environments that are seen as broadly harmful. The result is that inflation and interest-rate expectations can influence not only the overall market but also sector leadership within the market.
With that said… the relationship is rarely simple. Markets are complicated ecosystems filled with competing forces. Inflation may rise because economic growth is strong, which can simultaneously support corporate earnings. A company may possess pricing power that allows it to pass higher costs on to customers. Technological innovation may offset inflationary pressures in certain industries. Human behavior, investor sentiment, and geopolitical events further complicate the picture. Like many aspects of investing, the challenge is not identifying a single cause-and-effect relationship but understanding how multiple variables interact.
There is also a slightly more philosophical lesson embedded within the discussion. Investors often seek certainty from economic data that was never designed to provide certainty. Inflation reports are estimates (uh, at best). Forecasts are projections. Expectations are educated guesses. Yet markets frequently react to these figures as though they were immutable laws of nature. In some respects, inflation data resembles a weather forecast. It may tell us something useful about the environment, but it does not guarantee sunshine or rain. The temptation is to treat every monthly report as a definitive answer when, more often than not, it is merely another piece of evidence in an ongoing conversation. Humorously (at least, as I see it), few activities demonstrate humanity’s confidence quite like watching economists revise inflation forecasts, investors revise their expectations, and then everyone explain afterward why the outcome was obvious all along. Hindsight remains one of the most accurate forecasting tools ever invented! The percentage of people who were actually “correct” at the time is FAR smaller than the percentage who later claim they were. I call this the Jim Cramer Effect… but I digress.
The broader point is that inflation matters because its influence extends far beyond the price of everyday goods and services. Whether current inflation readings are accurate reflections of economic conditions, whether future projections ultimately prove correct, and whether markets occasionally overreact are all subjects worthy of debate. What is far less debatable is that inflation affects how investors think about the market, how the Federal Reserve sets interest rates, how companies manage their businesses, and how equity markets are valued.
For that reason, investors pay attention to inflation. Not because inflation is the only variable that matters, but because it influences many of the variables that do. Understanding inflation does not eliminate uncertainty, nor does it provide a roadmap for short-term market movements. It does, however, help investors better understand the environment in which markets operate. And in investing, understanding the environment is often more valuable than attempting to predict every change in the weather.
