Inflation is the decline in purchasing power of a given currency over time. It is usually estimated based on the increase in the average price of a basket of goods and services in the economy over a period of time.
Effectively, it refers to the same dollar value in currency being able to buy fewer goods or services over time. A commonly used inflation index is the Consumer Price Index, and it is often referred to in the news when there are reports on the economy of a country, region, or even the global economy.
The increase in the supply of money generally is one of the leading causes of inflation. And monetary policy that results in the pumping of money into an economy is called quantitative easing (QE). QE sees the central bank of a country or region printing, lending or giving away money to support growth.
For example, the US Federal Reserve engaged in QE at the start of the Covid-19 pandemic in 2020 to support the economy by providing liquidity. In the process, the Fed’s balance sheet ballooned as it propped up the economy.
As the economy stabilised and began to recover from the pandemic, improved economic conditions in addition to the Fed’s QE policy led to inflation numbers rising.
Initially, this was a good outcome as it headed off the possibility of a recession or deflationary pressure, but the inflation numbers have since risen to levels that have led to concern. Thus, the Fed has to initiate or hint at its intention to rein in inflation in recent months, leading to volatility and uncertainty in the currency, stock and bond markets.
Types of inflation
Inflation can typically be classified into three categories: demand-pull inflation, cost-push inflation and built-in inflation.
Demand-pull inflation occurs when the increase of money supply and credit leads to higher demand for goods and services. If the increase in demand outpaces the increase in production, this causes inflation due to heightened demand that is unfulfilled. Thus, inflationary pressure can be seen more in sectors favoured by consumers.
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For example, during the pandemic, there was a surge in demand for equipment to work from home, such as computer desks, computer monitors and other accessories. Also, there was an increase in demand for services such as food delivery in contrast to lower demand for restaurants.
Cost-push inflation occurs due to an increase in the cost of production, mainly due to an increase in the prices of raw materials, or a shortage of raw materials, or intermediary goods. For example, there was an energy shortage in the UK, China and other countries during winter in 2021. The pandemic led to energy demand plunging in the initial stages, especially when various countries resorted to lockdowns to control the spread of the virus. However, a surge in energy demand just a year later led to a supply-demand imbalance. The situation was further exacerbated by the global supply chain crisis, which affected the transport of raw materials.
Built-in inflation is generally the result of expectations of the other two types of inflation. If there is an expectation that inflation will continue, this will lead to the prices of goods and services rising, and the cost of labour increasing along with the expectations of a price rise as workers seek to maintain their standard of living. However, this increase in wages also leads to a higher cost of production which translates into higher costs for goods and services, thus causing a spiral effect.
What is the impact of inflation?
Inflation leads to increased value of tangible assets usually marked to a currency value, such as gold, physical property or commodities. Such assets therefore benefit from inflation due to their higher value. However, the reverse is also true for assets held in terms of monetary value, such as cash deposits, bonds and cash equivalents.
If inflation is at an optimal level, it stimulates the economy by encouraging the consumption of goods and services instead of only savings as inflation will erode the buying power of money over time. This consumption of goods and services then boosts the economies of countries or regions, which in turn leads to a stable increase in prices over time.
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However, if inflation is high or fluctuating, there is a mismatch of expectations of the value of money by businesses, workers and consumers. This leads to uncertainty in the economy where the prices could increase due to expectations instead of actual economic activities.
The opposite might also occur if inflation is too low, or in deflation, where consumers could choose to keep their money on hand in savings, due to perceived lower prices in future. This will lead to a lack of money supply and spending, which will cause prices to continue to fall due to a decrease in demand for goods and services. This could occur during recessions or stagnation of an economy, which can be seen in some parts of Europe currently, causing the European Central Bank to engage in QE.
Though some developed countries such as the US set their preferred inflation rates around 2%, developing countries that have a higher GDP growth rate have higher tolerance levels for inflation. This is because the growth of the economy outpaces or is at least on a par with inflation numbers, allowing the various drivers of the economy not to be negatively impacted by inflation.
Stock sectors that are affected by inflation
Commodities such as gold are often perceived as a good hedge against inflation. However, based on the price trends, gold might not always achieve this goal. Mining companies and the commodities sector generally perform well during inflation as they generate physical assets, which are in demand. The perception of continued inflation can also increase the demand for goods and services in the short term, which can then create higher demand for raw materials. Thus, the commodities sector usually performs well if inflation is due to cost-push inflation.
Demand-pull inflation benefits consumer products and services. For example, during the pandemic, the surge in demand for technology services and electronics led to better performance by the sector. The consumer discretionary sector also benefitted with higher demand for better quality furniture and electronic gadgets. This could be attributed to the travel restrictions leading to demand centring around physical goods.
Built-in inflation generally helps the F&B industry as well as the financial sector. With higher wages, workers are more willing to spend on better-quality food as well as seek investment options. Higher or stable income also promotes the purchase of residential property or vehicles which boosts the loans sector.
How to react to inflation and policies to control inflation
Inflation impacts various sectors of the stock markets due to various scenarios revolving around the underlying reasons for inflation. The surge in demand for technology services and home office equipment dropped as the pandemic began to come under control, and more countries loosened or removed control measures.
Inflation can also lead to currency rate depreciation if the inflation in the country is higher than that of other countries. This can benefit exporters as goods are more affordable overseas, while negatively impacting importers of raw materials or goods. In the case of Singapore, due to exposure to the export and import markets, the Monetary Authority of Singapore’s policies mainly target currency exchange rates instead of interest rates, which are commonly used in developed countries to control inflation.
Higher inflation would usually benefit sectors with physical assets such as real estate investment trusts (REITs). However, the current backdrop of a likely increase in interest rates by the Fed will impact the performance of these REITs, which are negatively impacted by higher rates due to increased interest costs for their debts.
Investors should thus consider the entire situation revolving around the expectation of inflation and the possible measures introduced by the governments to control it.
One sector that can outperform in this situation will be the financial sector, which benefits from higher interest rates due to an increase in their net interest margin and consequently the net interest income. Also, if inflation takes time to be reined in, consumers could choose to spend more during this period in the expectation of inflation running high for a longer period.
Teo Huan Zi is branch manager of Phillip Investor Centre (Toa Payoh)
