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Summary: Inflation - general price increases in society - is increasing at a rate, which hasn't been seen since the 1970s. But why is it increasing so drastically and suddenly? In this article, we have taken a look through the historical lens.
Since the financial crisis, equity markets have seen an unprecedented long period of higher and higher valuations. This may have led many to think that this will continue indefinitely and that the risk of equity investments, often emphasised by financial institutions, are overstated. If that’s been your conviction and you have been heavily invested in stocks over other asset classes, you quite possibly have suffered some losses in 2022. One of the reasons is that inflation has returned – and not just that; it has returned with a vengeance. Inflation in and of itself is generally considered a healthy sign for equity markets, but what they are reacting to now is that too much inflation is bad for the economy and that forces central bankers to intervene, which is one of the reasons why markets are falling.
To understand this, we have to look at what happened during and after the financial crisis. When the American bank Lehman Brothers collapsed in 2008 and the world’s financial markets basically grinded to a halt, central banks and politicians feared that the global economies would collapse with it. Remember that the financial crisis was in large part fueled by overly aggressive mortgage lending. This practice pushed millions of people into foreclosure and forced them to sell their houses with crippling losses, which rocked the inflationary cycle.
As people defaulted on their house, they had less money to spend on goods, services etc. This led to companies earning less, which then forced them to either halt salary increases or lay people off. This led to fewer jobs, less salary, fewer taxes paid to the state, less money for consumption, lower income for companies etc., which can lead to deflation.
Inflation is a fancy word for the increase in prices for goods and services, a society sees over time. Inflation is measured by tracking a basket of goods over time and see how their prices evolve. Most famous is the US Consumer Price Index, which is produced by the American Bureau of Labor Statistics.
Deflation is the opposite of inflation, or it is negative inflation. Said in another way, deflation is when prices fall. Generally speaking, deflation is poison for economies as it incentivises less production, less consumption and less development, and thus, central banks were faced with the task of getting inflation back on track.
Imagine this example: You are considering buying a washing machine, which costs 1,000 USD today, but since there’s deflation, you know that the price will probably fall, so in a couple of months’ time, you may be able to buy it for 800 USD. What will you then do? Probably wait, right? When that happens, productivity and consumption in a society grinds to a halt. Then central banks need to motivate people to spend money, which e.g., can be done by lowering interest rates or even make people pay to save through negative interest rates. In this way, the deflationary circle should be able to be reversed – people start buying again, which is good for companies, they hire more people, who pay more taxes etc.
While this has been the tool to historically solve such crises, 2008 was such a deep one that especially the US and European central banks quickly found themselves with rates of zero or even negative interest rates without seeing any real effect on inflation.
Making a long story short, this leads us to the introduction of Quantitative Easing, which, for the purposes of this story, should just be thought of as the most supportive financial conditions companies have ever had in the history of finance. Borrowing money was never as cheap and risk-free as it was after the financial crisis and the central banks grew increasingly weary of tightening conditions, because the few times they did, the markets crashed in spectacular fashion. This financial environment for companies has been one of the main reasons why equity markets have been able to keep increasing for over a decade – or what is referred to in high-finance as a bull market. The initiatives drove inflation above zero, but it remained below or close to the two percent annual inflation mark, which most central banks aim for.
Then, since 2020, the world has experienced a pandemic, which surprisingly sent many people on a spending spree, which led to increased commodity and labour shortages and brought on lockdowns that pressured supply chains. Coupled with an energy crisis and macro political turbulence, you suddenly had a lot of different factors, which all push prices upwards and thus we now see this ketchup-bottle inflation, where suddenly the floodgates are open, which leads to a drastic increase in inflation, which central banks need to toil fast – if they believe it is here to stay.
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