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Will Inflation Cause the Next Stock Market Crash?

By Dan Caplinger - Updated Feb 15, 2018 at 4:19PM

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Even the beginning of a potential trend momentarily spooked investors.

The stock market's movements over the past month have led more investors to pay attention to whether a market crash is likely in the near future. The latest sign of skittishness among market participants came on Feb. 14, when the Bureau of Labor Statistics released January inflation data. The news that inflation was stronger than expected sent stock futures into a momentary tailspin before the beginning of trading that morning.

January's inflation report did show signs of higher prices, and after years of being able to ignore the potential ravages of inflation, investors aren't used to seeing the potential for a flare-up. Should you be worried about the implications of rising inflation on the stock market? A closer look at the actual BLS report can shed some light on exactly what's behind recent price increases and whether they're troublesome.

Six rolls of increasing denominations of U.S. currency.

Image source: Getty Images.

Running hot

The headline numbers for the Consumer Price Index report seemed to justify alarm. The CPI rose 0.5% in January on a seasonally adjusted basis, which was the largest monthly increase for the index since September 2017. The monthly increase took the measure's gains to 2.1% over the past year, rising above the 2% target the Federal Reserve typically states as its goal for price increases.

A substantial portion of that increase came from the always volatile energy sector. Monthly price gains amounted to 3% for energy, with particularly outsized increases in the commodities that Americans use every day. Gasoline prices were up 5.7% for the month, while heating oil responded dramatically to winter conditions, soaring 9.5%. Even reductions in prices for electricity and natural gas weren't enough to offset the upward pressure that gasoline and heating oil had on the sector.

Looking to the core

Economists understand that items like food and energy tend to have volatile price shifts, and so they typically look at what's known as core CPI readings that ignore changes in food and energy prices. That measure also showed a disturbing push higher, with a 0.3% monthly gain marking the biggest increase in that benchmark since January 2017. Even so, the annual increase came out to 1.8%, staying below the 2% Fed target.

Investors started paying closer attention to inflation after the release of employment figures showed an unexpectedly large rise in wages. Average hourly earnings climbed $0.09 to $26.74 in January, following an $0.11 move in December that has lifted wages by nearly 3% over the past year. With unemployment at its lowest levels in years, some believe labor shortages could prompt further wage pressure that in turn could force businesses to lift prices.

Some other economic factors could contribute to higher prices. The falling U.S. dollar against the euro and other key currencies could make imports costlier, especially from Europe. Rising demand from businesses looking to capitalize on tax savings through greater capital investment will make it easier for suppliers to raise prices, and that could lead to those costs getting passed through to end-customers.

What inflation means for investors

Investors have already seen the bond market react to higher inflation concerns. The 10-year Treasury yield hit 2.9% recently, and some see 3% as an inevitable rise in the near future. Rising Treasury rates often feed through to consumer loans like mortgages. Moreover, the Fed traditionally responds to higher inflation by raising short-term rates, which in turn affects credit card rates and many home equity loans.

However, as stock market participants saw following the CPI announcement, stocks don't always suffer as a result of inflation. The companies that provide the goods with rising prices can actually benefit from inflation, and consumers are in a strong enough position that businesses can feel more confident than usual in raising end prices to cover any cost increases along the supply chain.

Keep an eye on inflation

It's unlikely that the inflation increases seen so far will cause an imminent stock market crash. But inflation is a good measure to watch as an early warning indicator of economic pressures that can contribute to a less favorable environment for the financial markets. If January's numbers become the new normal rather than just a one-month anomaly, then investors will want to pay very close attention to inflation.

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