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Abstract: The relationship between inflation and stock market pricing has been a source of fascination for researchers for decades, and with the emergence of the Covid-19 pandemic and g

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THE RELATIONSHIP BETWEEN HIGH INFLATION AND THE STOCK MARKET PRICE

Part A: Individual Research Project (1972 words)

I Abstract:

The relationship between inflation and stock market pricing has been a source of fascination for researchers for decades, and with the emergence of the Covid-19 pandemic and growing inflation, there has been renewed interest in the subject This research report aims to examine the relationship between high inflation and the stock market price To find the answer, we will examine the relationship between the US Inflation rate and the US Stock market in 2021-2022 amid the United State worst inflation spike in nearly 40 years In addition, we also explain how the relationship between the two could change and the fall in stock market price due to the impact of the economic response taken by the US Federal Reserve in an effort to reduce inflation

II Introduction:

In the financial world, there is a long history of research into the influence of inflation on asset prices starting with the so-called ‘Fisher effect’ or ‘The theory of Interest’ by Fisher published in

1930 which advanced the idea that the expected return of an asset should equal to the expected rate of inflation pointing to a positive relationship between inflation and asset prices However, subsequent theoretical and empirical papers found evidence and demonstrated explanations for a potential negative relationship (Albulescu, Aubin & Goyeau 2017) With many nations now experiencing growing inflation, there has been renewed interest in the subject to examine and predict how a high inflation rate may affect stock market prices in the future

As a result of the US Government and FED economic responses to the largest contraction in the US economy since the Great Depression of the 1930s, which constitutes the largest and longest slump in economic activity in US history caused by the outbreak of the Covid-19 pandemic, the United States is now facing its worst inflation rise in the last 40 years which made the investors ever-increasingly concerned about the stock market's reaction and federal response

to growing inflation Many investors are concerned that the US FED's reactionary response of restrictive monetary policy would cause the US stock market to decline in 2022

In order to gain a better understanding of the relationship between high inflation and stock market prices, we will examine the impact of growing inflation rates in the United States and the

US FED's reactionary response of restrictive monetary policy on the US stock market in this paper

III Main body:

1 Cause of high inflation?

WION (2021) stated on January 13th that the United States is facing its worst inflation spike in nearly 40 years According to the US Bureau of Labor Statistics, US inflation increased

by 7% between December 2020 and December 2021 as seen in Figure 1, and commodities such

as energy, food, transportation, and medicare prices have climbed across the board over the previous year, affecting the lives of US citizens and causing pain to consumers (Aratani, L 2022)

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Figure 1: 12-month percentage change, Consumer Price Index, selected categories, not

seasonally adjusted by US Bureau of Labor Statistics, n.d.

Figure 1 depicts the largest increase in US inflation in decades, as evidenced by a sharp increase in the percentage change of the Consumer Price Index, which measures what consumers pay for a wide range of goods, at the start of the year 2021, accumulating to the highest increase

in US inflation in decades by 7% compared to December 2020

Siegel, R (2021) and Mishra & Mishra (2021) noted that the current spike in US inflation is spurred by a devastating Covid-19 pandemic that has roiled the global economy, disturbing the workforce and supply chains, while government stimulus measures worth trillions of dollars have helped unleash strong demand for commodities, resulting in demand-pull and cost-push inflation

The rising cost of hiring, transportation, and materials due to shortages caused the shift in the Aggregate Supply (AS) curve to the left from A to A which move the Equilibrium (E) to and price increase from to which constitute cost-push inflation While the US Government stimulus checks worth trillions of dollars provide money to struggling citizen suffering from the pandemic (AS English 2022), increase the money supply to the economy and encourage consumer demand

causing demand-pull inflation (Dinh 2020) which shift the Aggregate Demand (AD) curve to the right from A to A and increase the price further from to to more inflation and a New Equilibrium

2 Empirical literature review

According to Singh & G (2020), a study found that the relationship between inflation and stock price in the US evolves over time and is not constant The relationship between inflation and stock market reaction has been studied for a long time, with many studies pointing to a mixed outcome of either a positive or negative relationship between the two over the years In the case of the US, they observed that in the 1840s, 1860s, 1930s, and 2011, the relationship is highly positive, but in other time periods it is strongly negative (Singh, Padmakumari & McMillan 2020)

The case of a negative relationship between inflation and stock price has been supported by several historical events in the United States, such as the inflation rate in the 2008 subprime mortgage crisis that sparked the Great Recession spiked sharply by 5.6 %, resulting in a 48.54 % fall in the index, and the instance in 2011 when inflation jumped to 3.8 %, causing the index to fall by 12.75 %, as shown in Figure 2s (Drozdovica, J 2021)

Figure 2: US Inflation rate VS Dow Jones Industrial Average by Jekaterina Drozdovica, 2021

3 Impacts on the stock market

Figure 3: The Dow Jones Industrial Average, S&P 500 Index, and Nasdaq Stock Market Composite of the US stock market from January 2021 and January 2022 by WSJ, n.d.

Figure 3 on the other hand depicts the current positive relationship between inflation and stock price as the value of the Dow Jones Industrial Average, S&P 500 Index, and Nasdaq Stock Market Composite, which is the three most widely followed US indexes used to measure market performance, rising throughout the year 2021 despite the volatility caused by high inflation, as shown in Figure 1 (Banton, C 2021)

The reason for the stock price increase despite the Covid-19 triggering a sharp drop in global economic activity, a collapse in trade, and a severe rise in unemployment that resulted in a contraction in the US economy that was compared to the Great Depression of the 1930s, which constitutes the largest and longest slump in economic activity in US history, was due to the swift Government responses in the form of stimulus checks and the FED's monetary expansionary policy successful in cushioning the economic consequences of the COVID-19 crisis In

comparison to a no-policy benchmark scenario, research shows that monetary expansion resulted

in higher output growth and stock market returns, better long-term financing conditions, and a depreciation of the US currency (Feldkircher, Huber & Pfarrhofer 2021) The actions of the US government and the Federal Reserve helped to create an upbeat economic outlook with a strong economic recovery despite inflation concerns, which increased investor expectations about the state of the economy's recovery and encouraged investors to invest in stocks, driving up stock prices (Jackson, A & Schmidt, J 2022) The stock market reaction can differ depending on the condition of the economy for both positive and negative inflation shocks, i.e., the effect of inflation on stock returns is dependent on how investors interpret inflation in different economic states (Singh, Padmakumari & McMillan 2020)

4 The stock market fear in 2022

After many investors considered 2021 to be a good market year, things are about to change

as investor fear and nervousness have increased since the US Federal Reserve signaled its intention to combat the pandemic's rampaging inflation by adopting a restrictive monetary policy

of selling off Treasury bonds and mortgage-backed securities accumulated during the pandemic, reducing the money supply, and increasing interest rates (Schneider, H & Marte, J 2022) Their anxiety is justified, as many studies have shown that a restrictive monetary policy and higher interest rates reduce stock prices (Bissoon et al 2016) After the FED signaled its intention to engage in restrictive monetary policy to combat the rampaging US inflation rate, this causes a brief investor panic, resulting in a decline in the Dow Jones Industrial Average, S&P 500 Index, and Nasdaq Stock Market Composite of the US stock market after 3 January 2022 This could signal the start of the stock market's downfall in 2022

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Figure 4: The effect of decreased Money Supply on the Interest rate

When the US FED applied the restrictive monetary policy in 2022 as an attempt to quell the high inflation rate by selling off Treasury bonds and mortgage-backed securities accumulated during the pandemic, reducing the money supply Then in theory, in the Money Market (Figure 4), it would cause the Money Supply curve (S) to shift to the left from to A new Equilibrium is created (from to ) and Interest rate increases from to

Figure 5: The effect of increased Interest rate on the demand for the stock.

Borrowing becomes more expensive for consumers and businesses when interest rates rise Companies' profit margins may suffer as a result, and equities may become less appealing to investors, while consumer demand is stifled as a result of consumers having less money to spend (Marcos, C.M & Flitter, E 2021) It would result in the Demand curve (D) shifting to the left from D to resulting in a lower price level (P to ) and lower quantity of stock demanded (Q to )

IV Conclusion:

In this paper, we examine the relationship between high inflation and stock market prices by examining the impact of the United States' current high inflation rate on the US stock market and possibly answer the question of how a high inflation rate could affect the stock market

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In the Empirical literature review, we examined the findings of the theoretical and empirical paper about the relationship between high inflation and stock market prices and found that the relationship between inflation and stock prices in the United States evolves over time, with many studies pointing to a mixed outcome of either a positive or negative relationship between the two over time It is consistent with the findings of the investigation on the impact of the US stock market's present high inflation rate The history of the US financial market has shown that in some instance when the inflation rate rise, the stock market fall

In the main body part 1, we investigate what is causing the United States' high inflation rate The cause is the result of the Covid-19 pandemic disrupting the labor and supply chains, resulting in cost-push inflation, and the US government's trillion-dollar stimulus package stimulating strong consumer demand, resulting in demand-pull inflation

Next in part 3, we investigate the effects of high inflation on the US stock market We discovered that the relationship between the inflation rate and the stock market price is positive, with evidence indicating that the Dow Jones Industrial Average, S&P 500 Index, and Nasdaq Stock Market Composite, the three most widely followed US indexes used to measure market performance, rise throughout 2021 despite the volatility caused by high inflation

In part 4, we examine how the relationship between the two could change in the future as

we research into the investor fear in 2022 of why the US FED’s reactionary restrictive monetary policy in an effort to reduce the US inflation rate could cause the US stock market to decline However, the result of this part is subjective as it lacks evidence to support that it could happen

in the future and the relationship between the two could turn from positive to negative

V References:

1 WION 2021, US inflation at nearly 40-year high | Mismatch in supply & demand fuels crisis | English News | WION, YouTube, 13 January, viewed 14 January 2022, <

https://www.youtube.com/watch?v=TsRzfihTf1Y>

2 Aratani, L 2022, ‘US inflation jumped 7% in December as prices rise at rates unseen in decades’, The Guardian, 12 January, viewed 14 January 2022, <

https://www.theguardian.com/business/2022/jan/12/us-inflation-rate-december-2021>