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Inflation & Interest rate: Impact on the stock market and Indian economy

ICICI Securities 16 Sep 2022

One of the most common topics of discussion today in every home is the increasing cost of household items. You don't need to be a financial guru to understand inflation. It is part of our lives and pretty much visible. For an investor, it is vital to understand inflation and its role in the Indian equity market and the broader economy. In this article, we discuss - inflation, interest rates, and their impact on the Indian economy.

Understanding inflation

Inflation is a rise in the price of goods and services and a decline in the purchasing power of citizens. Each one of us has witnessed it. There was a lot you could do with Rs 1,000 a decade back, but today, with the same amount, you can buy fewer things. In other words, you need to pay more money for the same thing.

As children, we all used to love having Maggi. Back then, a packet of Maggi used to cost Rs 10. It weighed 100 grams, enough to satisfy our hunger. Because of rising inflation in India, Maggi's size was reduced to 70 grams in phases (you buy less at the same price). The quantity could not be brought down further (for obvious reasons), so the company increased the cost to Rs 12 (you pay a higher price for the same quantity).

Inflation is real, but you may still be wondering why it happens. For that, you need to understand the concept of Demand and Supply. If the supply of a product is constant and more people want it, then the prices will go up as some people are willing to pay a higher amount for it. If the supply is high and the demand is less, the seller has to reduce the price to attract customers. 

Above, we have discussed a generic reason for the rise in inflation. In 2022, inflation is high across the globe due to multiple reasons:

  • Increase in energy prices
  • Post pandemic, oil demand recovered more quickly supply
  • The Russia-Ukraine war caused the supply side issue for multiple items
  • Recurring shutdowns in China impacted the world economy by disrupting the supply chain

Another question that may bother you is - how is inflation controlled? To answer that, we need to introduce and explain a new term - Interest rates.

What are interest rates?

The interest rate is a percentage of the principal amount that the lender charges you for borrowing the money. The central bank in every country uses interest rates to make sure prices are stable (inflation is under control). The interest rate is the base rate at which banks can borrow money from the central bank. 

If you have to do anything with the equity market, you would know that investors closely track interest rates as it plays a crucial role in the country's economic development, stock prices, and other investment decisions. We will understand it more as we move ahead in our discussion.

How are the two related: Interest Rates and Inflation

Why is inflation increasing in India? We are talking about the broader economy and not just the price of a particular good. The main reason for increasing inflation is the rise in the money supply in the Indian economy. When the money supply increases, inflation goes up and vice-versa.

The central bank (Reserve Bank of India) tries to control inflation by changing interest rates. But how? Currently, we are in a rising inflation cycle - inflation is over 6% (above RBI's comfort zone). The reason is the higher money supply in the economy post-pandemic. 

Now RBI is increasing the interest rates. When the interest rate increases, you will save more as you will get a higher interest rate on your deposits. Also, for businesses, the cost of borrowing increases, and hence they won't borrow from a bank. As a result, the money supply in India will decrease, and inflation will come down.

Interest rate increase: Impact on individuals and the Indian economy

There is no doubt that the government and central banks have to work toward bringing inflation under control. Inflation is a problem not only in India but also in other developed nations like the USA. In India, the RBI is continuously increasing interest rates to control inflation.

Let us look at the impact (positive and negative) of higher interest rates on the Indian economy:

Cost of borrowing: When the central bank increases the interest rate, it increases the cost of borrowing for banks. The banks pass that cost to consumers (higher home loan rates) and businesses. If you plan to take a home loan in 2022, you will get it at a higher rate compared to last year.

Higher deposit rate: The interest you earn on savings accounts and fixed deposits tends to increase.

Weaker rupee: An increase in interest rates also accelerates the pace of capital outflows (FIIs exit), which leads to a weakening of the rupee.

Impact on the stock market: The stock market's performance is governed largely by corporate earnings. It means that if companies are expected to grow and earn more, the better it will be for the market. A company's growth becomes questionable when the interest rate is increased by the central bank. Sectors like banking, finance, real estate, and consumer durables are more rate-sensitive. Hence, they may get more impacted. However, it does mean that investors should stay away from the equity market when interest rates are increasing. Sectors like insurance, technology, pharma, and energy are less impacted by the interest rate increase. Investors may consider investing in them.

How do increasing interest rates in the US impact the Indian stock market?

Every time there is an update from the Fed's meeting on the interest rate, you will see volatility in the Indian equity market. Why does the rise in interest rates in the US market impact the Indian stock market? Let us understand it as equity investors need to understand macroeconomics at least at a high level.

You need to know that investors (Foreign Portfolio Investors) from the US invest in India and other emerging markets. They do so because the US Treasury's yield (assured return instruments like FDs) is low (when inflation is under control). As a result, they prefer investing in the emerging market to earn a higher return. In 2020, we saw FIIs investing crores every month in the Indian economy.

FIIs made excellent returns in the next 18 months as the Indian equity market rallied. The Fed has begun to raise interest rates. Hence, investors pulled money from the Indian equity market and invested in the safer US treasuries, which now give decent returns. Please see net FII outflows data since the beginning of 2022 to better understand this point. 

The Indian equity market fears that if the Fed goes aggressive with an interest rate increase in the US (as inflation is a bigger worry in the US), the FIIs may pull more from the Indian market. 

Conclusion

As a retail investor, there is nothing in your control related to inflation, interest rates, and their impact on the Indian economy and equity market. However, if you understand the relationship between them, you will become a better investor. You will understand the stock price fluctuations and other macroeconomic numbers. We hope we were successful in making you understand it. 

Disclaimer: ICICI Securities Ltd. (I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.

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