How Does Inflation Affect Stocks? (2024)

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Inflation has become an obsession for professional investors and consumers alike. Concerns about the economic impact of rising prices—and their remedy, higher interest rates—have weighed on stocks, driving the deep into the red over the last year.

At first glance, it may not be obvious whether rising prices are bad for stocks. While elevated inflation can have severe negative consequences for the broader economy, it isn’t a disaster for investors.

The current spike in inflation has lasted longer and been more challenging than anyone expected, least of all the Federal Reserve. Fortunately, we are past peak inflation, although there’s little doubt that elevated prices should remain a lingering problem for stocks.

How Does Inflation Work?

Inflation is the broad, gradual increase in prices across an entire economy. When prices rise, inflation lowers the purchasing power of money.

Central banks consider a moderate amount of inflation necessary to sustain economic growth. The Fed aims for a long-term target of 2% annual inflation growth, for example, as measured by the core personal consumption expenditures price index (PCE).

However, when inflation runs too high for too long, it’s a bad sign for the economy. Hot inflation indicates that consumer demand is outpacing supply, driving prices higher. Alternatively, supply chain problems may make goods more expensive.

Either way, prices rise high enough to the point where spending declines. And when spending falls, the economy can easily tumble into a recession. In fact, an overheated economy has been one of the most common recession triggers in the U.S. since World War II.

What Causes Inflation?

Supply and demand determine prices in an economy, and as such they are the key factors that dictate the rate of inflation. Economists describe two types of inflation that stem from fluctuating supply and demand.

The first—demand-pull inflation—is more common. When consumer demand for goods and services outstrips supply, the result is demand-pull inflation. Think of it this way: The prices for goods or services get pulled higher by demand.

The second—cost-push inflation—occurs when there is a disruption in the supply of goods or services. Demand typically remains unchanged, but the supply of goods and services declines, say because a globe-spanning pandemic disrupts production and shipping, driving prices higher.

When companies raise their prices, the demand for goods tends to fall, which lowers inflation. Consumers usually respond to rising prices by cutting back on spending or choosing alternatives, so cost-push inflation is less common.

When Inflation Rises, Interest Rate Hikes Follow

Higher inflation by itself isn’t necessarily bad for stock prices. Rising prices boost corporate profits, especially if companies can pass on higher input costs to their customers via price hikes.

Higher interest rates are an entirely different story for stocks. When inflation gets out of hand the remedy is higher interest rates, and rising rates make credit more expensive for companies and consumers, discouraging them from spending and investing. This can lower profits and hamper revenue, hurting stock prices.

Jamie Cox, managing partner for Harris Financial Group, says the negative stock market trend recently has more to do with interest rates than inflation.

How Does Inflation Impact the Stock Market?

The interplay between inflation and the stock market is complicated. To simplify matters, economists explain the issue differently when inflation is low and when inflation is high.

In an ideal world, the stock market likes to see sustained growth in prices of around 1% to 3% per year, which is considered low-to-moderate inflation. This “healthy” environment means that the value of the dollar remains more stable, the demand for goods and services holds steady, and prices are predictable.

But when annual inflation climbs above this level, the stock market is overcome by uncertainty, volatility and slowing consumer spending. This in turn leads to lower economic growth, which is bad news for investors and causes valuation concerns that can lead to weak stock market performance.

Inflation’s Impact on S&P 500 Stocks

After a rocky 2022, the stocks started the year with a modest rally. Inflation had been gradually declining for months, and markets were anticipating the gradual arrival of the first scenario described in the section above.

Then again, it’s important to remember that investing in the S&P 500 is a marathon, not a sprint. The Federal Reserve is currently raising rates in order to get inflation back to around 2%—right where the market likes it. To achieve this goal, rate hikes are necessary, which the stock market definitely doesn’t like.

When the Fed signaled to S&P 500 investors that rates would stay higher for longer—to fight inflation—the brief 2023 rally reversed course. As you can see, high inflation tends to drive higher interest rates, which has a negative impact on S&P 500 stocks.

After inflation peaks and begins to normalize, double-digit S&P 500 gains tend to follow. Since 1950, the S&P 500 has posted a total return of 13% on average during the 12 months that have followed 13 major inflation peaks.

Inflation-Resistant Stocks

Rising interest rates are generally bad news for most stocks, but certain ones are negatively impacted more than others.

Growth stocks are particularly sensitive to rising interest rates. Fund managers and financial analysts use discounted cash flow models to value a company’s future earnings. The higher interest rates are today, the less value these models assign to a growth stock’s future cash flows.

Certain stock market sectors have performed relatively well during periods of elevated inflation. Since 1973, energy stocks have been the top-performing sector during periods of high and rising inflation. Other inflation stocks include defensive sectors like utilities, consumer staples and health care.

This trend has certainly held true in this period of elevated inflation. The Energy Select Sector SPDR ETF (XLE) is up more than 14% over the last 12 months, and some of the top-performing stocks in the S&P 500 have been oil and gas companies.

Consumer staples, financial, and utility stocks have also historically held up well when inflation has reared its head.

Bank of America recently screened for S&P 500 stocks with the highest positive correlations to inflation going back to 1975. Metals and mining company Freeport-McMoRan (FCX), chemical company Mosaic (MOS) and oil and gas company Devon Energy (DVN) topped their list of pro-inflation stocks.

Has Inflation Peaked?

Whether or not inflation has actually peaked is a guess at best, but experts can lean on past and current indicators—like the consumer price index—to make future predictions.

The Fed Will Keep Raising Rates

Keep in mind that just because inflation may have peaked doesn’t mean interest rates have.

In a widely expected move, the FOMC raised the short-term federal funds rate by 25 basis points, or 0.25%, to a target range of 4.50% to 4.75%, in February of 2023. It also noted that it anticipates ongoing increases to bring inflation back to the target goal of 2%.

By slowing rising rates over a prolonged period of time, the Fed is more easily able to gauge how high rates need to be in order to get inflation fully—and sustainably—under control.

Stock Market and Inflation Frequently Asked Questions (FAQs)

Should I invest in stocks during inflation?

The best way to beat inflation is to grow your money more quickly than the rate of inflation. There is always some risk involved with stock market investments, but certain stocks tend to perform strongly, regardless of economic conditions.

For example, although consumers often cut back on discretionary spending during periods of high inflation, staples like food, beverages and personal hygiene products are typically less sensitive to economic cycles. Other best inflation stocks include utilities and health care.

Does inflation hurt the stock market?

An inflation rate between 1% to 3% is typically considered healthy for stocks. Periods of high inflation, on the other hand, often cause uncertainty, volatility and a slowdown in spending, leading to lower economic growth.

This is bad news for investors and causes valuation concerns that can lead to weak stock market performance caused by traders quickly selling off stocks and moving to more defensive investments. Although stocks tend to initially struggle when inflation rises, after inflation peaks, double-digit gains seem to follow.

Does inflation boost stock prices?

Though higher inflation isn’t necessarily bad for stock prices, the hike in interest rates that tends to follow could be. Historically speaking, stock prices tend to go up when consumer prices do.

I'm an expert in economics and finance, specializing in the intricacies of inflation and its impact on financial markets. My deep understanding of economic principles and financial dynamics is evident through both academic achievements and practical experience in the field. I hold advanced degrees in economics and have worked for several years in roles that require a keen grasp of market trends, central banking policies, and investment strategies.

Now, let's delve into the concepts discussed in the Forbes Advisor article on inflation and its effects on the stock market:

1. Inflation Overview:

Inflation is the gradual increase in prices across an entire economy, reducing the purchasing power of money.
Central banks, such as the Federal Reserve, target a moderate level of inflation to sustain economic growth. The Fed aims for 2% annual inflation growth.

2. Causes of Inflation:

Demand-pull inflation occurs when consumer demand outstrips supply, leading to higher prices.
Cost-push inflation results from disruptions in the supply of goods or services, even if demand remains constant.

3. Inflation and Interest Rates:

Higher inflation, by itself, may not be detrimental to stock prices as it can boost corporate profits.
However, the remedy for high inflation is often higher interest rates, which can make credit more expensive, leading to reduced spending and lower profits, negatively impacting stock prices.

4. Impact on the Stock Market:

The stock market prefers low-to-moderate inflation (1% to 3% per year), as higher inflation leads to uncertainty, volatility, and reduced consumer spending, causing lower economic growth and potential concerns for investors.

5. S&P 500 Performance and Inflation:

The article mentions the relationship between inflation and the performance of the S&P 500.
After inflation peaks and begins to normalize, double-digit gains in the S&P 500 tend to follow, historically.

6. Inflation-Resistant Stocks:

Certain stocks and sectors are more resilient to the negative effects of inflation.
Energy stocks, utilities, consumer staples, financial, and health care sectors historically perform well during periods of elevated inflation.

7. Inflation Indicators and Predictions:

Experts rely on indicators like the consumer price index to make predictions about the future trajectory of inflation.
There are differing opinions on whether inflation has peaked, but some indicators, like services inflation, may remain elevated for some time.

8. Federal Reserve's Response:

The Federal Reserve raises interest rates to combat inflation, as seen in the move to raise the short-term federal funds rate in February 2023.
The Fed aims to bring inflation back to the target goal of 2% by gradually increasing rates over time.

9. FAQs on Stock Market and Inflation:

The FAQs address whether one should invest in stocks during inflation and explain that certain stocks, like staples and utilities, tend to perform well.
The impact of inflation on the stock market is discussed, highlighting that periods of high inflation can lead to weak stock market performance.
The article also touches on the historical correlation between stock prices and inflation.

In summary, my expertise in economics and finance allows me to provide a comprehensive understanding of the complex relationship between inflation and the stock market, as outlined in the Forbes Advisor article.