Explainer: Why are markets falling?

High inflation has brought the global stock market party to an end.

The Dow Jones Industrial Average, America’s premier stock market index, is down more than 8 per cent in the last one month. It closed at 31,730.3 points on May 12. Nasdaq Composite, another widely followed index in the United States, has dropped around 17 per cent in the last one month.

Cryptos are having a tough time as well. Bitcoin, the crypto with the most following, has fallen by more than 26 per cent over the last one month. At the time of writing this bitcoin was priced at around $30,000. The price of Terra Luna, another crypto, fell by 100 per cent in the last few days. Almost all crypto exchanges have suspended its trading.

Gold has been having a tough time as well, with the price of the yellow metal falling 8% to around $1,819 per ounce in the last one month.

So, why is this happening? Inflation in the rich world has reached decadal highs. Retail inflation in the United States was at 8.2 per cent in April and 8.6 per cent in March. This kind of inflation was last seen in the early 1980s, more than four decades back.

In the United Kingdom, the retail inflation was at 6.2 per cent in March, the highest since February 1992, when it had stood at 6.3 per cent. In the Euro Area the retail inflation in March stood at 7.4 per cent, the highest since January 1997, when the figure was calculated for the first time. Euro Area is the monetary union of 19 countries which are a part of the European Union and have adopted the euro as their main currency.

There are three reasons for this inflation. First, in the aftermath of the Covid pandemic, central banks of the rich world printed trillions of units worth of their currencies. This was done to drive down interest rates in order to encourage individuals and businesses to borrow and spend more. The idea was also to help governments short on taxes to borrow at low interest rates. A part of this money was also directly handed over to citizens improving their spending capacity.

Second, global supply chains broke down as the Covid pandemic spread. What hasn’t helped is China’s zero tolerance Covid policy, which has led to many factories shutting down and breaking supply chains in a highly globalised world.

This led to an environment where people in the rich world were looking to spend money and at the same time the supply of goods was negatively impacted due to supply chains breaking down. This sent the price of goods surging.

Third, Russia’s attack on Ukraine made things worse. Among other things, Russia is one of the top exporters of oil, coal, fertiliser, nickel and wheat. This supply has been impacted and prices have gone up further. In fact, this has led to food inflation across large parts of the world.

In this environment, in order to control inflation which disproportionately impacts the poor, the central banks of the rich world have started raising short term interest rates. Earlier, this month the Federal Reserve of the United States raised a key short-term interest rate by fifty basis points. It plans to keep raising rates all through this year.

Along with this, the Fed also plans to gradually take out all the money that it had printed and pumped into the financial system in order to drive down long-term interest rates. The American central bank has plans of taking out up to around $1 trillion from the financial system over the next one year, starting from June 1. The Bank of England and European Central Bank are expected to follow the Federal Reserve. The likelihood of this happening has started to push up interest rates all across the world. Higher interest rates will dampen consumer demand. A lower consumer demand will ensure that the price rise eventually slows down to comfortable levels.

What this basically means is that the era of easy money which started in late 2008 when Lehman Brothers, the fourth largest investment bank on Wall Street went bust, may be finally coming to an end.

Vivek Kaul is the author of Bad Money.