Reviewing the Current Inflation and Interest Rate Scenario

This month the US Central Bank (Fed) kept interest rates unchanged at 5.25 – 5.50 percent, while the European Central Bank (ECB) raised rates by 25 basis points to 4.50 percent, in their respective monetary policy meetings. High inflation has been an inimical issue for the last two-and-a-half years – and central banks have been raising interest rates – to bring inflation within their target range.

Both the Fed and ECB have an inflation target of 2 percent. In the US, the inflation rate for August 2023 was 3.7 percent; in the Euro area, it was 5.2 percent – both running above their respective central bank’s target rate.

ECB, in the policy announcement, said that rates have reached a level restrictive enough to bring inflation down to the target: this could be interpreted as an implicit notification that they are almost done with rate hikes. The Fed has shown it explicitly by keeping rates unchanged in the latest meeting.

It is the gradual decline of inflation over the last one-and-a-half years that has driven the Fed and ECB to pause rates for now – despite inflation remaining above their respective target of 2 percent. In the Euro Area, the inflation rate has declined from the peak of 10.6 percent in October 2022 to 5.2 percent in August 2023; meanwhile, in the US, the inflation rate has declined from the peak of 9 percent in June 2022 to 3.7 percent in August 2023.

In India, inflation after bottoming out at 4.31 percent in May 2023 spiked in recent months: it stood at 7.44 percent and 6.83 percent for July 2023 and August 2023. RBI raised policy rates by 25 basis points in its first policy meeting of this year (Feb 2023) but kept it unchanged over the next three subsequent meetings.

What do these recent developments – on the inflation and interest rate front – mean for stock prices?

For stock prices to appreciate sustainably – companies should be able to achieve sustainable earnings growth – which is possible only in a stable economic condition – and low, stable inflation is imperative for sustainable economic growth and stability. However, despite moderating over the last one-and-a-half year, inflation in India and globally remains above central banks’ comfort levels. Therefore, we need to see inflation staying low for an extended period to be convinced that it has been anchored.

Moreover, the recent spike in oil prices triggered by production and export cuts by Saudi Arabia and Russia has increased uncertainty and risk – on the inflation front as well as the economic outlook. The Brent Crude Oil price gained almost 30 percent over the last three months – from $75 per barrel to $97 per barrel.

Regarding interest rates: Historically, periods of rising interest rates are challenging times for markets and stock prices. At the same time, higher interest rates set the stage for the next bull market.

So, are we done with interest rate hikes?

I think… despite the recent pause in rate hikes by central banks… it is too early to conclude that the present global rate hike cycle is over… because… inflation… despite the recent moderation… hasn’t been fully anchored.

If we consider the rally in stock prices from the March 2023 bottom, it is reasonable to presume that the positive developments – moderating inflation and pause in rate hikes – are more than incorporated into stock prices. However, the risk posed by the recent oil price spike doesn’t seem to be fully reflected in the stock prices either.

Equity investors should approach the current market cautiously. A wait-and-see approach would do better than harm.

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