How Does Inflation Affect Interest Rates

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Research suggests that we are in a suprasecular period of declining, ultra-low actual interest rates. As a result, some investors have even questioned the Federal Reserve’s relevance.

Yet, the global supply chain disruption has wreaked havoc on the global economy over the last year, with inflation rising to 6.8% in November. The Fed has responded by signaling that it is prepared to raise interest rates in 2022.

So, “How does inflation affect interest rates?” you ask. Let’s find out so you can make quality decisions to protect your savings and manage your finances and investments.

How is Inflation Measured?

Inflation is a sustained, general increase in goods and services. This means that the purchasing power of each unit of currency declines, meaning you can buy fewer goods and services.

Inflation is measured through the inflation rate, the annualized percentage change in the consumer price index (CPI), or other general price indexes.

The CPI is computed by the Bureau of Labor Statistics and is the price of a weighted average market basket of consumer goods and services purchased by the typical household. So, this basket does not include assets such as homes or securities.

Which Factors Affect Interest Rates

Interest rates are compensation for an investor or lender foregoing current consumption. Consequently, factors that influence the need for investors to be compensated affect interest rates.

Although Paul Schmelzing’s work shows that secular trends drive interest rates down within particular periods, specific factors can work to keep rates in line with this trend or raise interest rates.

The most critical factors driving interest rate movement are:

  • First, interest rates rise when inflationary expectations are high to compensate investors and lenders.
  • Interest rates respond to the riskiness of investments and the investment climate. The higher the risk, the higher the rate.
  • Tax rates may force investors and lenders to demand higher interest rates to compensate them for tax losses.
  • Banks can raise interest rates to slow down the economy or reduce them to promote economic growth.
  • The state of the economy affects interest rates. A strong economy leads to high-interest rates and a weak one to low-interest rates.

Impact of Inflation on Lenders v Borrowers

For lenders, inflation is bad. If inflation is more significant than expected, the interest charged will be insufficient to compensate for the loss of purchasing power during the loan period. As a result, a lender will receive less money than was loaned out.

For borrowers, greater-than-expected inflation is a positive because they will repay less in real terms than was borrowed.

Remember: nominal values remain the same, but actual values decline during the loan period.

In summary, the nominal repayment values stay the same, but there are vital differences

  • the lender will see a decline in the actual value of sums loaned out. For the lender, this is a decline in revenue.
  • The borrower will see a decrease in the real value of the repayment amount. For the borrower, this is an increase in revenue.
  • lenders will respond by either increasing interest rates in line with inflationary expectations or,k if they are prevented from doing so, reducing how much they loan out
  • if rates do not adjust, borrowers will be encouraged to borrow more money

How Can I Protect My Finances from Inflation?

Asset markets are like banks, and you should invest in assets whose expected return is greater or equal to the expected inflation rate to protect your investment.

Investing in passive stock market indices is the best inflation hedge.

Preferred stocks are another avenue, as they will pay a higher yield than bonds and will not decline as much as bonds do during periods of inflation.

Buy Treasury inflation-protected securities (TIPS), which increase in value in line with inflation.

Buy senior secured bank loans, which earn higher yields during inflation. As rates increase, the value of the loans increase.

How Will Inflation Affect My Pension?

Typically, if you have a pension plan, you are indirectly invested in the stock market and other instruments. This is because pension funds are some of the most prominent participants in the stock market. Given, as we said, that stocks are the best hedge against inflation, generally, your pension will be secured.

Typically, pensions grow in value faster than inflation. For instance, between 2015 and 2019, pensions grew by 7.4% per year, compared to an inflation rate of 1.53%.

However, this depends on the specific investment policies of the pension plan you are under.

Summary

Inflation erodes the purchasing power of money. This means that you can buy fewer goods and services than you could in the past.

Banks typically raise interest rates to cool the economy down and reduce inflation in response to rising inflation. As a result, lenders suffer from inflation, and borrowers benefit from it.

Higher interest rates mean that the cost of borrowing increases, helping lenders, such as the financial institutions that the economy needs to survive.

To protect yourself against the risk of inflation, it is essential to remain invested in asset markets, particularly stock markets, and look at instruments like TIPS as a hedge against inflation.

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