To understand why low inflation is good for stocks (and high inflation is bad), it’s important to understand the relationship between a stock’s price-earnings ratio and inflation.

Inflation is a general rise in the price level. In a low-inflation environment, a dollar holds its value going forward. In a high-inflation period, a dollar’s value erodes over time as a rising price level decreases the dollar’s buying power.

Investors generally assign P-E ratios, in part, on the basis of a firm’s earnings-growth capability. Companies expected to have fast-growing profits are generally afforded higher P-E ratios than stocks with modest growth prospects. Why? Because investors are willing to pay a premium for growth.

A P-E ratio reflects expectations for future earnings growth. The better the expected earnings growth, the higher the P-E ratio, all other things being equal. Now, what if inflation is running at high levels? In this scenario, the future earnings of a company are not going to be worth as much because of the effects of inflation. If the value of future earnings is expected to be affected adversely by inflation, then investors will not be willing to pay as much today for a company’s future earnings. What that means in terms of a company’s P-E ratio is that investors will not be as willing to assign high P-E ratios, since the value of the growth is discounted by inflation.

The upshot is that P-E ratios contract during periods of high inflation. During periods of low inflation, the future value of earnings retains its value, which means investors are willing to pay a premium for growth (or higher P-E ratios).

Once you comprehend the relationship between inflation and P-E ratios, it’s easy to understand why inflation is so closely watched by investors. High inflation means contracting P-E ratios, which means lower stock prices. If inflation is low or falling, P-E ratios expand, which means higher stock prices.