Daily Economics, Business, and Finance Study

October 16, 2026 (KST) · Day 26
Today's Topic: Why Do Inflation Shocks Move Interest Rates and Stock Prices Together? — Inflation Expectations, Real Rates, and the Central-Bank Reaction Function

1. Review of the Previous Lesson

Day 25 explained that the CPI, PPI, and GDP deflator cover different prices and that higher inflation does not automatically mean higher corporate profit. Today, we connect an upside or downside inflation surprise to inflation expectations, real interest rates, the expected central-bank policy path, and equity value.

2. Today's Core Concept

What matters to markets is not only the absolute inflation number. The gap between the result and expectations, how persistent inflation is expected to be, and how the central bank is likely to respond are all critical.

Today's learning objectives are:

1. Decompose a nominal interest rate into expected inflation and a real interest rate.
2. Understand the difference between inflation expectations and breakeven inflation.
3. Read a central bank's reaction function through inflation, growth, and financial stability.
4. Connect higher interest rates to corporate cash flow, financing costs, and valuation.
5. Explain why stock prices can react differently to the same inflation release.

The core transmission chain is:

[ Inflation\ shock \rightarrow Change\ in\ inflation\ expectations\ and\ expected\ policy\ path \rightarrow Change\ in\ nominal\ and\ real\ interest\ rates \rightarrow Change\ in\ corporate\ cash\ flow,\ WACC,\ and\ valuation ]

3. Concept Explanation

3-1. An inflation shock begins with the gap between the release and market expectations

Financial markets price the future in advance. This is why a 3% year-over-year CPI reading alone is not enough to predict the market response.

• If the market expected 2.7% and the result is 3.0%, it is an upside surprise.
• If the market expected 3.3% and the result is 3.0%, it is a downside surprise.
• Even with the same actual reading, interest rates and stocks may react differently depending on prior expectations and positioning.

Immediately after a release, examine not only headline inflation but also core inflation, shelter and services inflation, the month-over-month rate, and revisions to prior data. Whether the result came from a volatile item such as energy or spread into persistent categories related to wages and services may matter more for the policy outlook.

3-2. Decompose a nominal interest rate into a real rate and expected inflation

A simplified Fisher relationship is:

[ Nominal\ interest\ rate \approx Real\ interest\ rate+Expected\ inflation ]

On an ex-ante, forward-looking basis:

[ Ex\ ante\ real\ interest\ rate \approx Nominal\ interest\ rate-Expected\ inflation ]

• Nominal interest rate: the stated rate on a deposit, loan, or bond.
• Expected inflation: the rate of future inflation expected by market participants and economic agents.
• Ex-ante real interest rate: the forward-looking rate measured in expected purchasing power.
• Ex-post real interest rate: the realized result calculated by subtracting actual inflation after the period has passed.

For example, if the nominal rate is 5% and expected inflation is 3%, the ex-ante real rate is about 2%. If actual inflation later turns out to be 4%, the ex-post real rate is about 1%.

The exact Fisher equation uses a multiplicative relationship, but when interest and inflation rates are not extremely high, the subtraction formula is a widely used intuitive approximation.

3-3. Inflation expectations are not a single number

The measure depends on the method.

If near-term expectations surge while long-term expectations remain near the inflation target, markets may view the shock as temporary. If five- and ten-year expectations also keep rising, markets may see a risk that expectations are becoming unanchored .

3-4. Breakeven inflation is a market-based approximation

In the U.S. market, the difference between a nominal Treasury yield and the real yield on a Treasury Inflation-Protected Security, or TIPS, at the same maturity is called breakeven inflation.

[ Breakeven\ inflation \approx Nominal\ Treasury\ yield-TIPS\ real\ yield ]

For example, if the ten-year nominal Treasury yield is 4.5% and the ten-year TIPS real yield is 2.0%, the ten-year breakeven inflation rate is about 2.5%.

It should not be treated as the market's exact forecast of average future inflation. It can also contain an inflation risk premium in nominal bonds, differences in TIPS liquidity, supply-demand effects, and tax effects. Survey-based expectations should therefore be checked as well.

3-5. Central banks target future, not merely current, inflation

Changes in the policy rate affect consumption, investment, employment, and inflation with a lag. That is why central banks do not set rates mechanically from one reported inflation number.

A simplified central-bank reaction function can be expressed as:

[ Policy\ rate \approx Neutral\ nominal\ rate +a\times Inflation\ gap +b\times Output\ gap ]

• Inflation gap: the difference between forecast inflation and the inflation target.
• Output gap: the difference between actual output and sustainable potential output that does not intensify inflationary pressure.
• Neutral rate: a theoretical rate that neither stimulates nor restrains the economy.

When the inflation gap widens and the economy overheats, the incentive to keep rates higher increases. When inflation stabilizes and demand and employment weaken rapidly, room for rate cuts may emerge.

This equation is a teaching device, not a fixed formula used by an actual central bank. The Bank of Korea considers not only inflation and growth but also financial stability, household debt, exchange rates, and capital flows. Trade-offs become more difficult when objectives conflict, such as when a supply shock raises inflation while weakening growth.

3-6. The policy rate and market interest rates are not the same

A central bank directly influences a very short-term policy rate, while the market determines the longer-term interest rates that matter for equity valuation.

[ Long-term\ nominal\ interest\ rate \approx Average\ expected\ future\ short-term\ rates +Term\ premium ]

• If inflation is higher than expected, markets may conclude that rate cuts will be delayed or that another increase is needed.
• If long-term inflation uncertainty rises, the term premium required for holding long-duration bonds may increase.
• If confidence in the central bank's inflation control is strong, long-term inflation expectations may remain stable while real rates rise.
• If recession fears dominate, long-term rates may fall even after a high inflation release.

The shortcut “higher CPI means all interest rates rise” does not always hold. Separate two- and ten-year yields, nominal and real yields, and breakeven inflation.

3-7. A higher real rate raises the discount rate applied to stocks

Enterprise value is the present value of future free cash flow.

[ Enterprise\ value =\sum_{t=1}^{n}\frac{FCFF_t}{(1+WACC)^t} +\frac{Terminal\ value}{(1+WACC)^n} ]

A rise in the real risk-free rate generally produces the following chain:

1. The risk-free base of the cost of equity rises.
2. Corporate bond yields and new borrowing costs may also increase.
3. WACC rises.
4. The present value of the same future cash flow falls.

Growth stocks whose earnings and FCF are concentrated far in the future have a longer equity duration and may be more sensitive to interest-rate changes. A company with large current cash flow and little debt may be relatively less affected.

3-8. Inflation changes both corporate cash flow and the discount rate

An inflation shock reaches equities through two routes.

Cash-flow channel

• Changes in selling prices and nominal revenue
• Changes in volume and consumers' real purchasing power
• Changes in raw-material, wage, and logistics costs
• Changes in working capital such as inventory and receivables

Discount-rate and financing channel

• Changes in sovereign real yields and the cost of equity
• Changes in corporate credit spreads and borrowing costs
• Changes in interest expense on floating-rate debt
• Changes in pension liabilities, leases, and impairment valuations

A supply shock is particularly difficult. Costs and inflation can rise while demand weakens, compressing corporate margins and making it difficult for the central bank to ease. In contrast, moderate inflation accompanied by productivity gains and recovering demand may be absorbed through revenue and profit growth.

3-9. Why the same inflation release can produce different stock-market reactions

Stocks respond to more than one interest rate. They reflect why the rate changed and how the earnings outlook and risk premium changed at the same time.

4. A Simple Numerical Example

The following figures connect a market move to hypothetical Company A. They are fictional figures for educational purposes, not a market forecast or investment recommendation. Rates are annualized; enterprise value and cash flow are in KRW 100 million.

① Decompose nominal yields before and after an inflation shock

[ Nominal\ yield\ before\ the\ shock \approx1.7%+2.3% =4.0% ]

[ Nominal\ yield\ after\ the\ shock \approx2.1%+2.7% =4.8% ]

Half of the 0.8-percentage-point increase in the nominal yield is explained by expected inflation and half by the real yield. The equity and corporate implications differ depending on which component changed.

② Measure the effect of a one-percentage-point rise in the discount rate

Assume Company A is expected to generate KRW 10 billion of FCFF next year and then grow perpetually at 3% per year. This is a highly simplified educational perpetuity model in which WACC exceeds the growth rate and all assumptions remain constant.

[ Enterprise\ value =\frac{FCFF_1}{WACC-g} ]

At an 8% WACC:

[ Enterprise\ value =\frac{100}{0.08-0.03} =KRW\ 200\ billion ]

If WACC rises to 9%:

[ Enterprise\ value =\frac{100}{0.09-0.03} \approx KRW\ 166.67\ billion ]

[ Change\ in\ enterprise\ value =\frac{1{,}666.7-2{,}000}{2{,}000} \times100 \approx-16.7% ]

Even with no change in the FCFF forecast, a one-percentage-point increase in the discount rate reduces calculated enterprise value by about 16.7%. In an actual DCF, growth by stage, taxes, debt, and risk premiums must be estimated separately, so this figure must not be used as a price target.

③ Calculate the effect of floating-rate debt on interest expense

Assume Company A has KRW 50 billion of floating-rate debt and the applicable rate rises from 4% to 5%.

[ Previous\ annual\ interest =500\times4% =KRW\ 2\ billion ]

[ Annual\ interest\ after\ the\ increase =500\times5% =KRW\ 2.5\ billion ]

All else equal, pretax profit and cash flow decline by KRW 500 million per year. The actual effect depends on the rate-reset date, hedges, average debt balance, and whether any interest expense is capitalized.

5. How to Use It in Stock and Company Analysis

① Read an inflation release in four steps

1. Relative to expectations: Was the result above or below consensus?
2. Composition: Was it driven by a temporary item such as energy or a persistent category linked to services and wages?
3. Rate decomposition: Did the nominal-yield move come from expected inflation or the real yield?
4. Corporate transmission: Assess the effect on revenue, margins, borrowing costs, and WACC for each company.

Do not conclude from the stock index's same-day move alone. Examine bond yields, exchange rates, and credit spreads together.

② Classify the cause of a rate increase first

• Growth-improvement type: Expected real growth and earnings estimates rise together. Cyclicals can strengthen even as yields rise.
• Inflation-concern type: Expected inflation and term premiums rise. This can hurt companies with weak pricing power and long-duration bonds.
• Tightening-repricing type: Real yields rise and expected policy easing is pushed back. High-valuation growth stocks can be sensitive.
• Fiscal and supply-demand type: Government-bond supply and the term premium lift yields. Inflation alone may not explain the move.

③ Build a checklist for corporate interest-rate sensitivity

④ Do not memorize mechanical sector reactions

• Banks may gain from higher lending rates, but funding costs, delinquencies, and credit losses can increase more.
• Insurers may earn higher reinvestment yields, but the valuation of bond holdings and liability duration must also be assessed.
• Growth stocks are sensitive to higher real rates, but high growth and cash generation can offset the discount-rate shock.
• Consumer staples may be defensive, but they are not safe if price increases reduce volume and market share.
• Commodity producers are affected more by the relevant commodity price, production costs, and capacity cycle than by inflation itself.
• REITs and property companies may benefit from inflation-linked rents while suffering from refinancing rates, asset-value pressure, and vacancies.

⑤ Compare the real rate with FCF Yield

The incremental compensation offered by an equity looks different when its FCF Yield is 5% and the long-term real government-bond yield is 1% versus 3%.

[ Simple\ excess\ FCF\ yield \approx FCF\ Yield-Real\ risk-free\ rate ]

Do not treat this difference as the complete equity risk premium. Growth, volatility, leverage, dilution, cyclicality, and the sustainability of FCF must also be considered.

⑥ Distinguish the cause of lower inflation

• If inflation slows because supply chains normalize and productivity improves, the rate burden can ease while corporate margins improve.
• If inflation slows because demand collapses, rates may fall while revenue and earnings estimates deteriorate even more.

Disinflation is therefore not automatically bullish for stocks. Use earnings estimates and credit markets to distinguish good disinflation from bad disinflation.

⑦ Use sensitivity analysis to define a range of outcomes

Do not rely on a single DCF price target. Compare at least the following combinations.

6. What to Find in Disclosures

Central-bank and market data: check outside corporate filings

The Bank of Korea's current inflation target is 2% in terms of consumer-price inflation, but actual rate decisions consider the medium-term outlook and risks to growth and financial stability rather than one month's CPI alone.

Use consistent conventions for market data:

• The same timestamp immediately before and after the inflation release
• The same maturity, such as two, five, or ten years
• Definitions of nominal yield, real yield, and breakeven inflation
• Intraday price versus closing price
• Percent versus percentage point
• The possibility that term-premium changes are embedded in nominal yields

Korean companies: DART

Financial Supervisory Service DART annual and quarterly reports provide the following items:

U.S. companies: 10-K and 10-Q

SEC EDGAR provides the following items:

• 10-K Item 1A — Risk Factors: inflation, interest rate, refinancing, demand risks
• 10-K Item 7 / 10-Q Part I, Item 2 — MD&A: changes in price, volume, costs, and interest expense
• Debt note: fixed/floating mix, weighted-average rate, maturities, covenants
• Market Risk: quantitative sensitivity to interest-rate and FX changes
• Derivatives and Hedging: interest-rate swaps and cash-flow hedges
• Goodwill and impairment: discount-rate and long-term growth assumptions
• Pension and postretirement benefits: discount rate and liability sensitivity
• Fair value measurements: effect of market rates on financial-asset and liability values
• Contractual obligations and liquidity: refinancing needs and available liquidity

Same-day sovereign yields, TIPS real yields, breakeven inflation, and consensus expectations do not appear in corporate filings. Obtain them separately from official statistics or reliable market data. Do not mix stock prices and yields from different dates or yields of different maturities.

7. Key Takeaways

• The market shock from an inflation release begins with the gap from expectations, composition, and persistence rather than the absolute number alone.
• A nominal interest rate can be approximated as a real rate plus expected inflation.
• Breakeven inflation is the difference between a nominal Treasury yield and a TIPS real yield, but it is not pure expected inflation.
• A central bank considers the balance among future inflation, growth, and financial stability rather than one historical inflation reading.
• The policy rate differs from long-term market rates, which reflect the expected path of short rates and the term premium.
• A higher real rate can raise WACC and reduce the present value of future cash flow.
• An inflation shock changes not only corporate revenue and margins but also interest expense, working capital, and valuation.
• Why a rate rose—growth, inflation, policy, or government-bond supply—matters more than the rise alone.
• Lower inflation has different equity implications depending on whether it came from better supply or collapsing demand.

8. Three Review Questions

Question 1

If the ten-year nominal Treasury yield is 4.4% and the TIPS real yield at the same maturity is 1.9%, what is the simple breakeven inflation rate? Give one reason why it cannot be treated as pure expected inflation.

Question 2

Assume fictional Company B will generate KRW 12 billion of FCFF next year and grow perpetually at 2%. Under the simple perpetuity model, what is enterprise value at an 8% WACC and at a 9% WACC, and by what percentage does it decline?

Question 3

Immediately after CPI exceeds expectations, the two-year government-bond yield rises sharply, ten-year expected inflation barely changes, and growth stocks fall. Explain what the market likely repriced and list three additional items to check in company analysis.

Answers and Explanations

1

[ Breakeven\ inflation =4.4%-1.9% =2.5% ]

The simple result is 2.5%. It cannot be treated as pure expected inflation because it can contain an inflation risk premium in nominal bonds, differences in TIPS liquidity, bond supply-demand effects, and tax effects.

2

At an 8% WACC:

[ Enterprise\ value =\frac{120}{0.08-0.02} =KRW\ 200\ billion ]

At a 9% WACC:

[ Enterprise\ value =\frac{120}{0.09-0.02} \approx KRW\ 171.43\ billion ]

[ Decline =\frac{1{,}714.3-2{,}000}{2{,}000} \times100 \approx-14.3% ]

Even with the same cash-flow forecast, the higher discount rate lowers calculated enterprise value by about 14.3%. An actual valuation must also reflect growth by stage, net debt, taxes, and changes in risk premiums.

3

With stable long-term inflation expectations and a sharp rise in the two-year yield, the market likely repriced a later start to policy-rate cuts or a longer period of high policy rates. Growth stocks may have reacted strongly because a larger share of their value comes from distant cash flows and is sensitive to a higher real discount rate.

Representative additional checks include:

• Whether the nominal-yield increase came from real yields or expected inflation
• The company's WACC and the long-term growth rate embedded in its valuation
• Fixed/floating debt mix, refinancing dates, and interest-expense sensitivity
• The effect of inflation on selling prices, volume, costs, and margins
• Whether earnings and FCF forecasts were also revised downward

Next Lesson — Day 27:
“Why Is There More Than One Market Interest Rate When There Is Only One Policy Rate? — Reading the Yield Curve, Short and Long Rates, and the Term Premium”