[Insight & Opinion] Investment Decisions Should Consider Inflation

Expansion of Inflation and Interest Rate Risks
Consideration of Their Reflection in Financial and Capital Markets

In June, the US Consumer Price Index (CPI) rose by 9.1% compared to the same month last year. This is the highest inflation rate since November 1981, marking the highest inflation in 40 years. This figure is surprising in two respects. First, US inflation is accelerating (generally exceeding 1% month-over-month), and second, a double-digit inflation rate is approaching rapidly. If this trend continues, we will soon witness the highest inflation rate in half a century.

The characteristics of US inflation this year can be summarized in two points. First, the headline CPI increase rate is very high. The headline CPI is a price index that includes goods and services across the economy, especially energy and food prices, which tend to be volatile. The US has a high overall consumer demand and a highly externally dependent economic structure, including gasoline, resulting in the highest headline CPI increase globally.

Second, the core PCE (Personal Consumption Expenditures excluding energy and food) inflation rate, while high compared to headline CPI, has recently stabilized. The US core PCE is not a price index but a variable reflecting the total amount consumers actually spent, considering price changes. The Federal Reserve (Fed) pays close attention to this indicator as a more fundamental measure of inflationary pressure. Recently, the core PCE inflation rate has shown signs of stabilization (generally around 0.3% month-over-month). This phenomenon occurs because consumers are reducing their actual consumption expenditures. Considering both indicators, US price inflation is very high, and the reduction in consumer spending suggests an economic slowdown.

Inflation significantly impacts economic activities such as personal consumption, corporate investment, government spending, income generation, and wealth redistribution, affecting the economic structure. Currently, investors participating in financial and capital markets are primarily focused on interest rate changes. Interest rates adjust the expected returns and risks of capital, debt, and assets, causing fluctuations in bond and stock prices. If other economic conditions remain unchanged, rising interest rates increase the risk of debt default and raise the required returns on capital, thereby lowering asset values.

The current US federal funds target rate is 1.75%, and Treasury yields are in the 3% range. The problem is that the federal funds target rate is too low compared to current US inflation. The Fed has been increasing rates by 25 basis points (bp) in March, 50 bp in May, and 75 bp in June, with growing concerns that the July Federal Open Market Committee (FOMC) meeting may see a hike exceeding 75 bp, possibly reaching 100 bp. Even with a 100 bp increase, the federal funds target rate would only be 2.75%. This is insufficient to curb the rapidly rising inflation and inflation expectations in the short term, leading to a likely continued perception that the upper limit for rate hikes must be raised.

The issue is whether the real economy and financial and capital markets, especially in most countries with greater economic and financial vulnerabilities than the US, can withstand such a high interest rate shock. However, investors should consider that the risks of inflation and rising interest rates are already significantly reflected in financial and capital markets. If inflation and interest rate risks increase beyond current levels, investors should exercise caution. Conversely, if these risks ease compared to now, investors should prepare to invest in high-quality assets during the price adjustment phase that has already occurred in financial and capital markets through the first half of this year.

Dongmin Lim, Economist at Kyobo Securities

This content was produced with the assistance of AI translation services.