Why Inflation and Interest Rates Impact Stock Prices

Matt Corthell, CFA, President and CEO |

To know how inflation, interest rates and stock prices are related, it's best to start with the causes of inflation. Inflation is generally either caused by increases in demand relative to supply or a drop in supply relative to demand. Surges in demand for goods and services are generally caused by governments providing money. Decreases in supply are generally caused by issues with production.

Think about the COVID environment we just went through.

In the early part of the pandemic the government provided money to people and businesses during the lockdowns. After the economy reopened the demand for travel surged while the supply of destinations more or less stayed the same, leading to higher prices.

During the same environment, we saw supply shortages. Different countries COVID policies led to lower production of goods and more difficulty bringing those goods to market. This all lessened the supply of things while the world still demanded toilet paper, medical supplies and many other things.

In short, inflation is a demand and supply imbalance.

To correct that imbalance, central banks raise interest rates, which makes borrowing costs higher. Higher borrowing costs have the impact of lessening demand, which should help to bring demand in balance with supply and therefore lower inflation. A $500k mortgage at 3% is $2,108 per month whereas at 7% its $3,327 or 57% more expensive, yikes! Generally, raising interest rates has a larger impact on goods and services purchased with borrowed funds and a lesser impact on goods paid for directly. Think homes and cars compared with food, energy and services.

Now we know how inflation and interest rates are connected, but what does that have to do with the price of stocks? Generally speaking, investors are risk averse. All else equal, they would prefer to have a higher return with less risk, obviously. In addition, bonds, CDs and cash are all considered safer investments than stocks. So as interest rates rise, the returns on safer investments increase directly. Many people may see a CD at 1% and say it's not worth it and take the risk in the market. When CDs pay 5%, an investor may avoid stocks in favor of a higher return on a safer investment. That is all to say when interest rates increase, the alternatives to the stock market offer more attractive returns and all else equal lower the demand for stocks and in theory lower their prices. This of course works in reverse. As rates fall, the demand for stocks generally increases as returns on safer investments become less and less.

It is important to understand that inflation and interest rates are some key factors that impact stock market prices but are not the only factors. The underlying fundamentals of the business, sentiment and other factors all play a role and as a result you can have periods where interest rates increase yet stocks still rise, and you can have periods where interest rates fall, and stocks fall.

If you have questions about how market factors can impact your financial situation, consider speaking with one of our advisors here.

 

This commentary reflects the personal opinions, viewpoints, and analyses of Wooster Corthell Wealth Management, Inc. “WCWMI” employees. The information presented should not be viewed as a comprehensive analysis of the topics discussed but instead is general in nature.

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