Ok, so you thought that inflation was a nerve wrecker for businesses and the economy. Wrong, the industry loves inflation. So you might ask, why is it that every time there is news about increase in inflation figures the stock markets nose dive. Valid point, in the course of this article we will also find out as to what really disturbs the stock markets and why businesses love inflation.
For us to understand the reasons and effects for high inflation currently existing in markets like India and China we will take the example of U.S. The US economy is experiencing just the opposite of growing markets like India currently, it is experiencing a down turn in the economy, high unemployment rates and very low inflation rate. The US inflation currently stands at 3.6% in May’11 which is actually good news for now. But in 2010 in US the average inflation rate was only 1.6% and –0.4% in 2009.
Infact, the US Fed was actually worried in 2010 that instead of reaching their inflation target of increasing it, they actually might experience deflation , which is the opposite of inflation. Deflation is a persistent decrease in prices and inflation is increase in prices.
So as consumers we would like to be in deflation economy ideally and enjoy the low prices. Trust, we would not like to be in such a situation. Lets see why? Low prices occur when there is low or less demand. There is less demand of goods when people have low purchasing power or have no disposable incomes. People have less or low purchasing power when they have no jobs or no savings. In US, a lot of people are unemployed- 9% and even after cheap, very cheap credit- 0% interest rate, nobody’s buying.
In turn, businesses and factories are shutting down or operating far below utilization capacities as there is no buying happening leading to low demand, and low prices. Therefore the real indicator for the US to watch out for now is, the industrial output, which actually fell by .4% in April ’11 compared to march ’11. Once the factories in the US are running above average capacity, it will be time to rejoice for the Americans. Increase in factories capacity utilizations will be an indicator of increase in the real demand and not just increased demand due to cheap credit, it will be an indicator of a turn around in the U.S. economy.
Factories will in turn employ people and therefore result in increase of employment rates and thus purchasing power. Purchasing power will lead to a higher demand leading to higher prices and eventually higher inflation.
No wonder inflation is cherished by industries in rising economies. Even after the rising input costs, the manufacturer is able to pass on the cost to the consumer which the consumer is willing to absorb due to high demand in economies like India and China.
Going back to the question of stock markets, why do stock markets fall at the news of high inflation if inflation is good for business. The answer is FEAR and SENTIMENTS. The stock market is a function of much more than just economic figures. The fear of markets is that economies like India will slow down if the interest rates are kept so high by the RBI in order to tame inflation. Higher interest would obviously mean lower demand for housing, autos, durables etc, as a result sentiments get affected and the markets get nervous.
However, very high inflation is also not good for the economy, as it can lead to hyper inflation where in the currency loses its value. In short, inflation is a funny animal, that’s why neither the RBI and or the government want to own it.
