Why inflation affects stocks, bonds, and economic growth

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Inflation and the investor

Inflation impacts the required rates of return on both stocks (SPY) (QWLD) (DIA) and bonds (BND) (TLT). Persistently low inflation hints that there isn’t enough demand forcing price pressures. It may also imply excess capacity in the economy or resource slack. Resource slack implies underutilization of labor and other resources. Underutilization implies that prices could stay low, or even fall in the future, leading to deflation. Part 4

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Deflation has several negative consequences. It sparks fears that consumers will postpone expenditures now, in the hope of lower prices in the future. It penalizes debtors and benefits creditors because it increases the real cost of debt payments. This reduces the debtors’ disposable incomes and further impacts consumption. In short, deflation prevents economic expansion. As a result, central banks try to keep to their inflation targets in order to prevent a deflationary spiral.

The Fed’s 2% mandate and stock returns

Price stability in the economy is important for companies. The Fed’s 2% inflation target helps keep inflation expectations well-anchored. This informs pricing decisions, both selling and purchase prices. Companies’ pricing decisions directly affect their revenues and profits. In turn, these decisions affect the returns on stocks, such as those included in the SPDR MSCI World Quality Mix ETF (QWLD), the SPDR Dow Jones Industrial Average ETF (DIA), and the SPDR S&P 500 ETF (SPY).

In the next two articles, we’ll consider major labor market indicators released last Thursday and Friday.

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