Understanding Inflation and Interest Rates

When investing, there are several factors that an investor should take into consideration. The risk of the investment and individual attitude to risk (e.g. are your savings protected?), goals for the investment, and how the investment and any income or capital gain are taxed all spring to mind when thinking about investing and the types of investment to make. One factor that is often overlooked is the effect of inflation and interest rates on investments, and how the two interact with each other.

Inflation

Over time, the cost of goods and services increase. This is inflation, and is usually measured as an annual percentage change over the same time a year earlier. Most people believe that inflation is a bad thing, though this is not necessarily true. A little inflation in an economy generally shows that there is demand for goods and services: in other words, the economy is growing.

There are two main theories as to the cause of inflation:

The first of these is that demand for goods exceeds supply. More people are seeking to buy homes, cars, household furnishings, etc. and manufacturers cannot keep up with the demand. This is called demand-pull: demand pulls prices up.

The second theory is called the cost-push, and this is where costs go up and force the prices of goods and services up. For example, higher wage settlements, currency devaluation, and value-added-tax increases will all cause the price of finished goods and services to rise without extra demand in the system.

Interest rates

Interest rates are a major weapon in a government’s battle against inflation, and are also used to generate economic activity.

Interest rates will often be raised to combat high or rising inflation. By raising interest rates, consumers are deterred from taking out loans because they are more expensive. And so the sales of big ticket items such as cars and houses will fall as demand decreases. High interest rates also have the effect of making inward investment into a currency more attractive, and this is likely to increase the value of a currency against foreign currencies. This will also cause the cost of imported goods to fall, and the cost of exported products rise comparatively.

So a rise in interest rates is likely to cause a slowing of demand for goods, a decrease in the cost of goods imported from abroad (and potentially higher demand for imported goods), and a fall in demand for our goods in export markets. Trade wise there is a tug–of-war between rising and falling demand, and history shows that overall high interest rates dampen demand and causes economic activity to fall.

When economic activity is faltering or stagnating, a government may lower interest rates in efforts to make borrowing costs cheaper and therefore raise overall demand. However, lower interest rates may lead to increasing inflation as demand in the economy picks up.

The effect of inflation on spending power

A major reason for investing is to increase wealth, or spending power, in the future. However, high inflation is a pull on spending power, particularly when investment growth cannot keep up with inflation.

Consider an investment of £1000 made today which returns 5% per annum. In 10 years that investment of £1000 will have grown to £1629 (excluding tax). That’s pretty good, and would seem a wise investment. However, now factor in inflation at 7% per annum through the same period. An item that could be bought today at £1000 would cost £1967 in 10 years in such an inflation environment. Even though the investment has performed well the spending power of the original investment amount has fallen dramatically, all because of inflation outstripping the rate of investment return.

If inflation remains high, and interest rates low, then the so-called ‘real rate of interest’ is negative: the value of money in interest bearing accounts falls over time.

What does all this mean to investors?

When real rates of interest are negative, investors either look for other ways to increase the value of their savings – for example by investing in higher risk assets such as equities – or spend their money today because it will be worth less tomorrow.

During a period of low interest rates, equity markets tend to rise. Businesses can borrow money more cheaply, making profit margins improve. Demand for goods and services picks up, and dividends paid out to shareholders become more attractive.

High interest rates have the opposite effect. Cash in the bank earns more, without the need to take the risk of investing in equities. Dampening consumer activity reduces economic growth, and the cost of borrowing and falling demand squeezes profit margins.

Conventional wisdom dictates that rising interest rates will cause equity markets to fall, while falling interest rates will cause equity markets to rise. However, as can be seen there is an interconnection with inflation. High inflation is usually a sign of greater demand in the economy which is good for companies and therefore share prices.

Perhaps of greatest importance to the effect of inflation and interest rates on investors and their investments is the root cause of the inflation. Demand–pull inflation can be good for companies, as consumers are able to absorb higher costs and mar=gins van be maintained or increased. Where inflation is cost-pushed, and does not lead to increasing demand, then margins are likely to be pressured and profits fall. For a while companies may be able to control profits by using cost cutting measures, but these will have a finite life and an end point.

In conclusion, investors’ should always watch inflation and the cause of inflation as this can give clues to future stock market moves. Markets that are led up by interest rate cuts are often led down when the cuts are reversed.