When the BLS released its inflation data, stock prices fell. Why does the stock market react to inflation fears?
Tim Schilling at the Chicago Federal Reserve Bank says, "The standard rule of thumb is that if the Fed increases short-term rates, longer term rates also rise. This makes holding bonds more attractive and people will sell stocks to buy bonds at the higher yield." Bond prices and interest rates move in opposite directions so if bond prices are falling, yeilds are increasing. If investors can earn more in bonds than in stock, it's rational to invest in bonds. So, how much should a share of stock cost?
Say you know for sure that HNI is going to pay a $1 dividend this fiscal period. If interest rates are 5% then you should pay $20 for a share. I calculated this number by using the formula: I=PRT. Assume that T equals 1, then 1=$P(.05). Dividing by .o5 means that a price of the office furniture maker should sell for $20 a share. Assume that inflation is a worry and the interest rate pops to 10%. Now, HNI only is worth $10. The value of alternate investments makes the financial markets unstable when investors are worried about what the Fed will do to interest rates.
Ultimately, investors know that the monetary authorities have the situation under control and shake off the jitters. As Mr. Schilling says, "However, I have been around long enough to know that a hike in interest rates can be reassuring to the financial markets. It reassures them that the Fed has the long-term inflation situation under control, thus long-term rates actually fall and stocks remain a viable investment."