This week saw data released that showed the rate of inflation hitting 1.6% in December. This was higher than expected and shows that the effects of a weaker pound may be greater than anticipated. While this could cause difficulties for consumers who gradually find their pay packets don't stretch as far as they did last year, it could also mean the FTSE 100 endures a difficult year.
The key reason for higher inflation is a weaker pound. This has caused the cost of imports to increase, which has now begun to filter through to price rises in the grocery sector in particular. Sterling has fallen in value since the EU Referendum in June 2016, dropping from close to £1 being worth $1.50 back then to as low as £1 being worth $1.20 recently. For any currency, that's a significant depreciation. But for one of the world's biggest currencies, it shows just how much confidence in the UK economy has deteriorated.
Of course, the weaker pound has also been caused to at least some extent by a fall in interest rates to 0.25%. There has also been an expectation that interest rates will slide further due to the economic uncertainty the UK could experience as it leaves the EU. It's anticipated that this may cause the Bank of England to adopt an increasingly loose monetary policy in order to stimulate the economy.
The effect of higher inflation on the FTSE 100 could be negative because of its potential to push interest rates higher. Although inflation of 1.6% is low by historical standards, it's expected to reach as much as 3% this year. This could cause the Bank of England to seek to raise interest rates in order to cool the effects of inflation, which would be expected to cause an appreciation of the pound.
This could cause a negative currency translation (or at least less of a positive one) for the FTSE 100's numerous companies that report in sterling but operate mostly abroad. As a result, it would be unsurprising for the FTSE 100's price level to come under pressure. In fact, it could be argued that much of its rise since the EU referendum has been due to a weaker pound that has flattered the sales and profits of the index's constituents. Without that premium, the FTSE 100 could be trading much lower than it is today.
Of course, in the long run the FTSE 100 is likely to deliver strong growth. Its yield of 3.6% indicates that it offers good value for money and since it's closely tied to the performance of the global economy, rather than the UK economy, its outlook remains bright. However, higher inflation could prove to be its Achilles heel in the short run, since it could spark higher interest rates and an end to sterling's depreciation. But remember, there's always an upside and in this scenario, the index could become an even better buying opportunity than it is today.
Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.