Inflation — the 2% Target

The primary mandate of central banks, as in the case of Sweden's Riksbank, is to maintain price stability. This is traditionally defined as an inflation of around 2 percent. A low and stable inflation functions as a lubricant for the economy. It gives companies and households a predictable environment for planning and investments, which facilitates long-term economic growth.

Too high an inflation rate erodes purchasing power and creates uncertainty, while deflation (falling prices) can lead to a deadly spiral of postponed consumption and investments.

An inflation of 2 percent is considered a balanced level where the risk of both deflation and too high inflation is manageable. This target gives the central bank enough room to lower the interest rate without ending up in negative territory, which can be inefficient and problematic for the banking system.

In addition, a moderate inflation can help adjust real wages without employers having to explicitly cut nominal wages, which is politically difficult.

When the inflation rate rises, central banks typically react by raising the policy rate. This makes borrowing more expensive, which slows consumption and investments and thereby lowers total demand in the economy. For the stock market, this means an increased discount rate, which directly lowers the present value of future cash flows and pressures share prices.

In addition, higher interest rates are a competitive factor against stocks, because interest-bearing assets become more attractive. Companies with high debt and low margins are extra vulnerable in such an environment.

At the sector level, inflation creates a redistribution of resources. Commodity sectors and companies with strong pricing power can often outbid higher costs and protect their margins. Consumer sectors, especially for necessities, can fare relatively well, while discretionary consumer goods and sectors with high capital consumption are hit hard.

An analyst must therefore assess how different companies' business models and price pass-through capacity are affected by the prevailing inflation environment.