Rising inflation and interest rates could be driving the stock market for the next couple of months so here’s what you need to know…

American consumer prices surged to a 13-year high of 4.2% — the highest since 2008 — worrying investors over a possible rise in interest rates if inflation continues.

How does this affect the stock market?

Inflation is a hot topic for financial publications, but why? To break it down:

• High inflation *usually* means higher interest rates.
• Higher interest rates mean lower consumer spending and higher business costs from borrowing.
• The likely outcome: lower business earnings, lower stock prices.

Anticipating falling stock prices, investors pre-emptively sold their shares — leading to the NASDAQ’s 2.7% fall last week when inflation numbers came out.

The best and worst case for stocks

Niels Jensen of Absolute Return Partners thinks there are a few possible scenarios for the case of rising inflation:

• Scenario 1 (best for stocks): Higher inflation is temporary and doesn’t cause any long-term consequences.
• Scenario 2: Higher inflation becomes the new normal.
• Scenario 3 (worst for stocks): Inflation remains high and ignored for a long period of time, policymakers suddenly raise rates, and a recession happens.

Jensen believes scenario 1 is most likely but the probability for scenario 3 is too high for comfort, at an estimated 30%.

So far, the Fed — which is in charge of the US’ economic policies — strongly views the current high inflation numbers to be only temporary.

But that’s where the danger is… If the Fed underestimates inflation, it could be forced to increase interest rates by large amounts at the very last minute and risk sending the economy into a recession (scenario 3).

Behind the scenes for rising inflation

Before investors panic over the 4.2% inflation increase, let’s examine the factors behind the rise in the Consumer Price Index (CPI):

• Semiconductor shortage increased prices of new/used cars and electronic devices.
• Supply chain disruptions skyrocketing commodity prices (i.e. lumber, copper and metals) and shipping/freight costs.
• Lifting lockdown restrictions allowing more to travel while flights, hotels and attractions still have to operate at reduced capacity, resulting in higher travel costs.

These factors raise business costs, forcing companies to up their prices to compensate — and pass along those costs onto their customers.

Since the causes are COVID-related, the price hike may be temporary and could drop once the economy reopens. But if not, and the Fed calls it wrong, the prices might stay high for all but one thing — stocks.

Preparing for the worst-case scenario: See our past articles here and here.