A recent article from the BBC reports that Major US indexes fell more than 1% as well as European bourses which saw steep declines among fears of a rising inflation rate.
At the same time, the UK’s FTSE 100 fell by more than 2.5%, pushing the index down to 6,929 after hitting a post-pandemic high of 7,164.
So, a rising CPI inflation rate, such as in U.S. where it has risen to 2.6% CPI from 1.7%, has caused markets to slip, why?
Well first of all let us illustrate why a low and stable rate of inflation is good, one reason being profit incentives.
A low and stable inflation rate within the 2% symmetrical target means that businesses can make a higher profit as the prices of their products rise, because of this, the inflation rate results in a higher profit incentive.
And this profit incentive is incredibly important for the economy as it attracts FDI, firms see they can make higher profits in nations such as America so they go and set up in the said nation.
Consequently, FDI means that these firms are organically expanding into the said economy, thus leading to the creation of additional capital within the economy due to gross investment resulting in an increase in the productive capacity of the economy.
In other words, inflation leads to a higher profit incentive which leads to FDI which results in an increasing productive capacity helping achieve long-term, sustained economic growth, a government objective.
This is significant as FDI can cause demand-pull inflation. This is because foreign direct investment, for example, Siemens in the UK, creates a new specialised industry that employs workers and, once finished, can export the surplus of goods to other nations. Therefore, the increase in employment with rising output yields an increase in aggregate demand, at the same time, the rising exports, a component of aggregate demand, will also result in demand-pull inflation as aggregate demand rises.
However, FDI offsets this rising inflation rate in the long-term as an increase in the productive capacity of the economy makes goods more plentiful and less scarce, thus lowering the rate at which price levels rise at.
Another reason why low and stable inflation is particularly good for an economy is that it lets businesses plan ahead. This means uncertainty within the economy is low as firms know they will make profits on their investments in the future due to rising price levels, hence, domestic firms are also incentivised to increase their operations, thus leading to a further increase in productive capacity for similar reasons which were previously illustrated.
However, what if inflation is too high or unstable? Well, this is what may have occurred in recent months, especially with the U.S. economy.
It is possible that the expansionary monetary and fiscal policy measures that the U.S. government and Federal Reserve have implemented such as $700bn in QE and the cutting of the federal funds rate combined with the fiscal stimulus of $1.9 trillion with the PPP program have ‘overheated’ the American economy.
So, because economies around the world could get carried away as consumers enter a spending spree due to newfound confidence, central banks may be forced to pull the plug and introduce contractionary monetary policy measures to prevent a bubble from occurring.
In an effort to stabilise growth, central banks will likely attempt to increase the base interest rate in the coming months as well as reduce quantitative easing so that borrowing and servicing debt is made more expensive for firms and consumers.
And this is why investors are fearing a rising inflation rate, they are anticipating the increase in costs that will come to them and the firms in which they are investing once contractionary monetary policy is introduced, a decision which is likely inevitable.
Hence, to save their own investments, investors have pulled out, causing stock markets across the world to slip as demand for stocks lowers, a likely temporary decrease as stock markets will likely rally in the coming months as we work ourselves out of the pandemic.
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