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What You Need to Know about Inflation

Inflation is like toothpaste. Once it is out of the tube, it is very difficult to put back in. It occurs when competition is missing. It then reduces our purchasing power and distorts the signaling effect of prices. Accordingly, it is important to avoid it. Which is why it is a key target value of monetary and structural policies.

What Causes Inflation?

Investors are afraid of inflation. They are afraid of loss of value and uncontrollable equity markets. But are investors right to see inflation as a bogeyman? What are the effects of inflation on investments?

In order to answer these questions, we need to understand how inflation or price increases occur. One cause of inflation is stronger demand on the consumer side. Another is when the production of goods becomes expensive, because raw materials cost more or wages increase, for example. Both lead to higher prices of goods.

Inflation Is Better than Deflation

Politics and businesses prefer slight inflation. For instance, the US Federal Reserve aims to achieve an inflation rate of 2 percent. This is because inflation generates growth. Companies invest in anticipation of higher prices. Because companies are doing well, they can also pay higher wages. As a result, consumers buy more. Both are important prerequisites for a healthy economy.

Furthermore, slight inflation protects against deflation, which could block economic growth and even lead to an economic crisis. Excessively high inflation, however, can also curb economic growth. This would excessively reduce purchasing power and, in turn, make investments unattractive.

Central Banks Control Inflation with the Prime Rates

For these reasons, central banks aim to maintain stable inflation. They do this especially using interest. If inflation is lower than desired, central banks lower prime rates. This gives companies access to cheaper credit. Investments become attractive and economic growth is stimulated, which affects the mood of consumers and inflation.

In contrast, if inflation is at risk of spinning out of control, central banks increase their prime rates. As a result, higher interest must be paid for credit, which puts a damper on corporate investment activity and private consumer spending. The falling demand affects the rate of inflation.

As long as we do not restrict free competition, we do not need to worry much about inflation.

Burkhard Varnholt, CIO Swiss Universal Bank / Deputy Global CIO

Consequences of Inflation for the Stock Exchange

In the financial markets too, inflation and especially rising prime rates are not without consequences. For equities, it is crucial to know how high inflation is. Moderate inflation, which goes hand in hand with healthy economic growth, supports equity price development. Too much inflation, in contrast, creates fear in the economy. The consequences for the stock exchange can range from uncertainty to panic selling.

For bonds, the picture is in two parts. Their development is driven less by inflation than the development of prime rates. For instance, existing bonds in the portfolio lose value as soon as higher interest is offered for newly issued bonds. In contrast, those who invest in newly issued bonds at the right time benefit from higher interest for the entire term.

Five Current Questions on Inflation

The questions were answered by Burkhard Varnholt, CIO Swiss Universal Bank / Deputy Global CIO for Credit Suisse.

  1. What is the inflation rate expected for 2018 and 2019?
    Our inflation forecast for Switzerland is around 0.5 percent, i.e. very low. In the USA, in contrast, inflation should be higher – we expect 2.3 percent. This is especially due to the weak dollar and the high current account deficit, through which the US automatically "imports" inflation in greater quantity than Switzerland.
  2. Is the fear of high inflation justified?
    Inflation is usually man-made. Its worst enemy is free competition. When companies set prices, this usually has less to do with the prevailing monetary policy than competitive price pressure. You could also say that globalization and digitalization have turned most companies into "price takers." As long as we do not restrict free competition, we do not need to worry much about inflation in such markets. In contrast, inflation occurs in all sectors where free competition is restricted. This applies, for instance, to healthcare or agriculture. In those sectors, consumers pay extra costs because the political powers that be do not want to permit entirely free competition.
  3. Which risk factors can lead to high inflation?
    First and foremost, a reversal of the previous factors. Every restriction of free competition – and this is, of course, one of the risks of the current trade tensions – increases the risk of inflation.
  4. To what extent should the prime rates of Federal Reserve Board, ECB, and SNB go up?
    The prime rates, for one thing, are closely correlated to economic growth. If the economy is growing strongly, the demand for capital increases. If this is the case, the prime rates should be increased. What's more, we are in a phase with uncommonly low prime rates, which is still marked by the financial crisis of 2008. This should normalize itself, since no economy can handle negative interest well in the long term.
  5. What is the impact of the expected inflation on equities and bonds?
    Inflation usually leads to an increase in capital market returns. These always consist of two components: an inflation adjustment and the real interest rate. For bonds with a fixed interest rate, every interest rate increase triggers a price loss. But we should not neglect the fact that an interest rate increase also improves the re-investment opportunities for investors.

    The influence on equities is less clear than the influence on bonds. Moderate inflation below 3 to 4 percent may lead to switching from bonds to equities. Which is why moderate inflation and rising equity prices often go hand in hand. Past a certain level, however, inflation begins undermining the value of equities.