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Why The Stock Market Celebrated 7.7% Inflation

7.7% inflation caused stock market rally

Credit Sesame on why 7.7% inflation caused a stock market rally.

A year ago, the news might have caused panic. On November 10, 2022 the Bureau of Labor Statistics announced that inflation had increased by 7.7% over the past 12 months. That’s a high rate of inflation – nearly twice the 50-year average annual rate. And yet, the stock market celebrated with a huge rally.

The fact that a 7.7% inflation rate was seen as cause to celebrate says a lot about how bad inflation has been over the last twelve months. In June of this year, inflation reached 9.1%, the highest level in over 40 years. Inflation rose by at least 1% a month in both June and July. Had that pace continued, it would have pushed inflation to over 12%.

In that context, it’s understandable that seeing inflation trending downward came as a relief. The latest report indicated inflation is a little milder than economists had expected, making it a pleasant surprise.

Although it made for a good day on Wall Street, it may be too soon to expect that high inflation is on its way out. Consumers need more than wishful thinking to deal with the impact of higher prices.

A bright spot in a bleak year for stocks

Upon seeing the favorable inflation report, Wall Street traders went on a buying binge.

The Dow Jones Industrials Average gained 3.7% that day. The S&P 500 was up by 5.5%, and the Nasdaq Composite by 7.4%. All in all, it was the best day for stocks in over two years.

The mood of celebration stood out even more because it’s been such a bad year for stocks. Prior to the November 10 rally, the Dow had been down by more than 10% so far in 2022, the S&P had been down by more than 20% and Nasdaq by more than 30%.

There are sensible reasons why investors like the prospect of lower inflation. However, there are also reasons to suspect the giddy reaction might have been a case of reading too much into a single inflation report.

Lower inflation boosts the value of future earnings

Stocks don’t typically sell at prices based on the value of the company today. They sell based on an expectation of what that company may be worth in the future.

That expectation depends on assumptions about what a company may earn in future years. Since stocks frequently sell for 20 or more times their current annual earnings, investors are looking many years down the road.

Inflation diminishes that outlook. The more prices rise, the less those future earnings are worth in purchasing power terms. The further into the future those earnings are expected to occur, the more that high inflation would erode their value.

That explains not only why stocks in general react badly to high inflation, but also why tech stocks often get hit especially hard. Tech stocks are often investing heavily and are still growing their markets. Thus, their current earnings may be minimal – or negative – but investors buy their stocks on the expectation of future growth. However, the further into the future that growth is expected to occur, the more inflation diminishes its value.

It’s not just high-flying tech stocks that are very sensitive to inflation. Bonds, though they are generally safer than stocks in most scenarios, react badly when inflation rises. That’s because their value is entirely based on future interest and principal payments. These are generally locked in at the time of purchase.

So, when inflation rises the value of those future payments is diminished. That’s why 2022 has been a rough year for bonds as well as stocks – and why the bond market rallied along with stocks when the November 10 inflation report came out.

Falling inflation could slow the pace of interest rate hikes

Stock investors had another reason to celebrate an unexpectedly mild inflation report. The sooner inflation eases, the sooner the Federal Reserve can stop raising interest rates.

The Fed’s interest rate policy involves trying to find a delicate balance. Raising rates can fight inflation by discouraging borrowing and thus cooling off spending. However, that slows the economy and risks causing a recession.

The Fed has made it clear that it plans to continue raising rates as long as high inflation remains a threat. Thus, the financial markets took a report of slower inflation as a sign that the Fed may soon be able to back off of its course towards higher rates.

Reality check

A rally amid a rough year for stocks is certainly good news. Millions of ordinary Americans have staked their retirement funding on stock investments.

It’s worth taking a moment to look at the inflation news rationally. While the recent inflation report was a step in the right direction, it’s a long way from representing the end of rising inflation and interest rates.

Here are some reality checks to put things in perspective:

  • 7.7% inflation may be lower than the inflation rate of the past several months, but it is still high.
  • Month-to-month inflation rates fluctuate a great deal. It’s important not to read too much into any one report.
  • Ominously, energy prices bounced back in October after declining over the three previous months. Meanwhile, food prices continue to rise at a faster pace than inflation in general. Because both food and energy prices tend to be volatile, economists often refer to a “core” rate of inflation that excludes those two sectors. Core inflation is currently lower than the overall rate of inflation. Core inflation rate may be a useful measure for economists, but households have to live with the reality of inflation on food and energy/
  • Even with inflation dropping to 7.7%, Fed rates are still nearly 5% below where they would normally be relative to inflation. So, this level of inflation is nowhere near low enough to dictate that the Fed should stop raising interest rates.

Beyond wishful thinking: what to do about your money

Since it would be premature to assume that high inflation is on its way out, here are three financial moves you could make:

  1. Pay down debt. In particular, credit card debt has become very expensive. Inflation has driven interest rates on debt higher, so this is a costly time to take on new debt. Even maintaining existing debt balances could take an oversized bite out of your budget, so try to pay more than the minimum payment on each credit card bill.
  2. Adjust your retirement savings targets. This year’s economy may have set your retirement plan back. Higher prices mean you need more money in retirement, while falling stock and bond prices may mean your nest egg has taken a hit. You may need to raise your retirement plan contributions to catch up.
  3. Work on your credit. Raising your credit score may qualify you for a better interest rate. That’s one way to slow the rising cost of debt. Monitor your credit, make your payments on time and try to reduce your credit utilization ratio.

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Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.

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Published November 15, 2022 Updated: November 14, 2022
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