Central bankers are renowned for adjusting interest rates when inflation begins to rise. However, there is often a misconception from the general public regarding the nature of inflation and the appropriate response from central bankers. Therefore, the primary objective of this insight is to examine inflation from a novel perspective and explain why central bankers increase interest rates even though it would not necessarily reduce the cost of production. This understanding provides the foundation for assessing how inflation and monetary policy decisions transmit through to financial markets, influencing both equity and bond valuations.

Inflation is generally defined as a sustained increase in the general price level of goods and services over time. This is a result of two fundamentally different causes: demand-pull and cost-push inflation.

Demand-pull inflation occurs when aggregate demand in the economy exceeds the economy’s productive capacity. In simple terms, consumers, businesses, and governments are spending faster than the economy can produce goods and services. Typical causes include strong economic growth, rising wages and higher employment, increased consumer confidence, expansionary fiscal policy and low interest rates that encourage borrowing. Subsequently, central bankers respond by increasing interest rates, which makes borrowing more expensive, reduces consumer spending, and slows aggregate demand.

Cost-push inflation occurs when the cost of production rises, forcing businesses to increase prices to maintain profitability. Unlike demand-pull inflation, this inflation does not arise because consumers are spending too much, but because the economy becomes more expensive to operate. Common causes include rising oil and energy prices, higher transport costs, supply chain disruptions, labour shortages, and geopolitical conflicts. A classic example is an oil shock. When oil prices rise, manufacturers pay more for transport and production. These increased costs ripple through the entire economy.

Demand-pull inflation often signals a healthy, overheating economy and can usually be managed through higher interest rates. Cost-push inflation, however, is more problematic because it represents a deterioration in the supply side of the economy. It reduces growth while simultaneously increasing prices, creating an environment of higher interest rates, lower economic growth, and greater market volatility. South Africa is a net importer of oil and therefore pays international prices denominated in USD. However, increasing South African interest rates does not make oil cheaper. So why would the South African Reserve Bank increase interest rates when oil prices rise?

The answer lies partly in the exchange rate. The value of the ZAR is heavily influenced by international capital flows. Global investors continuously compare the returns they can earn in different countries. If South Africa's interest rates are significantly lower relative to those in developed markets, investors may move their capital elsewhere.

For example, lower South African interest rates may encourage foreign investors to sell rand-denominated assets, resulting in a decline in demand for the ZAR. The subsequent depreciation of the currency against the USD increases the cost of imports, thereby contributing to higher inflation. If sustained, these pressures may ultimately give rise to a dangerous inflationary spiral.

Understanding the Impact of Inflation on Equity and Bond Valuations

Equity valuations

Higher inflation and interest rates generally place pressure on equity valuations for two reasons. Firstly, higher discount rates (the value of a company is based on the present value of its future cash flows). When interest rates rise, the discount rate increases, meaning future earnings are worth less today. This tends to reduce equity valuations, particularly for high-growth companies whose profits lie further in the future. Secondly, lower corporate profitability. Cost-push inflation can reduce margins because companies must absorb higher input costs or risk losing customers by raising prices.

Bond valuations

Bonds are especially sensitive to inflation. Investors demand higher yields to compensate for the loss of purchasing power caused by inflation. When inflation rises, existing bonds with fixed coupons become less attractive. As a result, their prices fall and yields rise as investors demand higher compensation. Conversely, when inflation is low or declining, bond prices tend to rise as future cash flows become more valuable in real terms and interest rate expectations ease.

In conclusion, inflation is not merely a measure of rising prices but a powerful force that influences interest rates, currencies, corporate profitability, and the valuation of financial assets. Understanding the distinction between demand-pull and cost-push inflation is therefore essential, as the appropriate response from central banks and the resulting impact on markets can differ significantly. For investors, periods of elevated inflation often create uncertainty and increased volatility across both equity and bond markets. However, by understanding the underlying drivers of inflation and how they transmit through the broader financial system, investors are better positioned to make informed long-term investment decisions rather than reacting to short-term market movements.

Prepared by: Dr Theuns Mans

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