Top 5 Ways Retail Inflation (CPI) Impacts the Stock Market

Retail inflation is also known as CPI (Consumer Price Index) inflation. It measures the change in prices that consumers pay for everyday goods and services. To make calculations, firstly, it tracks a fixed set of items, like food, clothing, and transport. Next, it calculates how their prices increase or decrease over time. This gives an idea of the “cost of living” for an average household.

Also, CPI reflects the purchasing power of consumers and shows how much they can buy with their money. It highlights how expensive certain goods and services are and gives an idea of the overall strength or weakness of the Indian rupee in the economy. These indications and factors significantly impact the stock market in various ways.

For more clarity, let’s check the latest CPI trends and study the top 5 ways in which retail inflation impacts the stock market.

• Increasing retail inflation impacts the stock market by reducing the purchasing power of consumers. This creates a lower demand for stocks.
• During inflationary situations, several investors sell off assets to manage higher expenses. This lowers stock market prices.
• Higher inflation generally raises interest rates, which makes borrowing expensive. This negatively impacts corporate profitability and also stock prices.

In August 2024, India's retail inflation increased to 3.65%. This rise means the overall cost of goods and services that consumers buy has gone up compared to the previous month. Food inflation, which makes up about half of the CPI, also saw a jump, rising to 5.66% from 5.42% in July. This indicates that food prices have become more expensive for consumers.

However, despite the rise, inflation remains within the Reserve Bank of India's (RBI) tolerance range of 2-6%. Although inflation has not breached the upper limit, it is still higher than the RBI's desired target. Currently, the central bank is making efforts to bring it closer to 4%.

Retail inflation (measured by the CPI) affects stock market performance by influencing:

• Consumer spending
• Corporate profitability
• Investor sentiment

Also, an increase or decrease in retail inflation changes demand for stocks and sector performance. For a greater understanding, study the 5 ways showing the retail inflation’s impact on the stock market:

1. Alters demand for stocks

The CPI tracks inflation. It measures the price changes of goods and services over time.

When inflation rises, investors predict higher future prices for goods and services. This causes concerns about reduced purchasing power.

To prepare for this, they usually sell some investments to cover expected higher expenses. Consequently, this leads to lower demand for stocks, which also lowers stock market prices.

2. Defines purchasing power of investors

CPI-based inflation affects the purchasing power of investors. It shows how much their money can buy. If inflation is higher than wage growth or investment returns, the real value of money decreases.

For example,

• Say inflation rises by 3%, but investments grow only 2%.
• In this case, investors lose purchasing power.

To protect against this, investors shift their investments to assets that grow faster than inflation, like stocks or real estate. This drives up their prices in the market.

3. Affects interest rates

Most central banks use the CPI to make decisions about interest rates. If retail inflation is increasing significantly above their target, they raise interest rates to control it. Now, it is pertinent to note that higher rates make borrowing more expensive for both consumers and businesses. Usually, this leads to reduced spending and investments.

Such a situation lowers demand for stocks and causes stock market prices to drop. On the other hand, if CPI is low, central banks lower interest rates to stimulate spending. This makes borrowing cheaper, which boosts demand for stocks and leads to higher market prices.

4. Impacts corporate earnings

Investors must understand that inflation can raise a company's costs and affect its profitability. For example, say the prices of raw materials or wages increase due to inflation. Now, companies will face lower profit margins.

In such situations, most stock market investors reconsider their investments, which causes stock prices to fall. However, some companies, especially those with strong pricing power, can pass these higher costs onto consumers. Such companies can maintain or even grow their earnings during inflation.

5. Brings changes to sector performance

Changes in the CPI affect different industries in varying ways. Numerous studies have shown that sectors like “retail” and “consumer discretionary” are more sensitive to retail inflation as they rely on consumer spending.

Now, if retail inflation rises, consumers generally cut back on non-essential purchases. This lowers demand in these sectors and causes stock prices to drop. On the other hand, if inflation stays low, consumers spend more. This boosts demand for goods and services in these sectors and increases stock prices.

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