Falling inflation may not be getting the same attention-grabbing headlines as we saw when the graphs were on their way up to the highest levels in recent history, but a drop in this key financial metric will have profound effects on our day-to-day lives and on financial markets.

How We Got Here

For most adults in their 30s and below, inflation was, until recently, an alien concept. It was a thing of the past, something that our parents and grandparents experienced in the 1970s and 1980s when central banks were forced to push interest rates into the double digits to bring things under control.

Even throughout much of the 1990s and 2000s, inflation was a tamed beast, with most Western economies sticking close to their 2% targets. However, that changed following the financial crisis and the decade and a half that have passed since.

Since December 2007, the Bank of England’s base rate of interest has been on a downward trend dropping from 5.5% in 2007 to just 2% a year later. It then remained at 0.5% between March 2009 and August 2016, when it was lowered even further to 0.25%. This was all in an attempt to stimulate the economy and get inflation back to 2%.

Finally, in 2022, central banks around the world succeeded in their aim. Except, they overcooked things slightly and saw inflation shoot up into double digits again, increasing financial pressure for people right around the world. They are, however, beginning to settle. Part of this is simply down to the gravitational pull of markets as they try to find an equilibrium between opposing forces, though interventions from central banks have also helped.

What Does it Mean for Financial Markets?

Anyone who has attended an economics 101 class will know that inflation is directly linked to interest rates and exchange rates, therefore, the downward trajectory of inflation will affect what happens to these other areas.

Out of the two, interest rates will make the biggest difference. Central banks are less likely to increase their base rates if inflation is trending downward, and they may slowly lower them. This will lower the cost of borrowing, encouraging more cash into financial markets and likely to push many instruments higher.

Lower interest rates can also spark more economic activity, driving up revenues in many industries. They also make traditional bank savings accounts less attractive, leading many savers to seek out higher-yielding alternatives, which are, more often than not, the stock market, currency market, and commodities market.

Dampened and Altered Effect Because of More Market Participants

In recent years, there has been a significant increase in the number of investors and traders participating in financial markets. This has been partially down to platforms like Equiti that have made online trading easier and more accessible to those who were traditionally excluded from gaining exposure to these markets.

Many of these retail traders have swum against the tide. Of course, the most obvious example was the GameStop saga in early 2021, but there are plenty of others too. These traders are often keen to ‘buy the dip’ and ‘HODL’, two activities that are not entirely aligned with normal market behaviour.

This may create uncertainty and unpredictability in some markets as inflation decreases. For the savviest traders, this could be an opportunity to experiment with new strategies to seek out market inefficiencies.

A Word of Caution

If the last few years have taught us anything, it’s that it’s we should expect the unexpected. While the academic theory of economics can teach us a lot, it often misses out the psychological elements that are also at play in the market. Therefore, investors and traders should continue to perform all their usual due diligence before opening new positions to ensure they’re confident in their analysis.