Inflation, interest rates, and what it all means

From CNBC to Twitter to conversations with friends and family - you’ve probably heard your fair share about inflation and rising interest rates in 2022.  This shouldn’t come as a surprise given their rapid increase and the associated economic impact.  

For context, US inflation hit levels over the summer that we haven’t seen since 1981 and the average interest rate for a 30-year mortgage has more than doubled since January.

The following is a breakdown from our financial planners of what the terms inflation and interest rate mean and how they are related. 

Inflation 

Inflation measures the general increase in prices for both goods and services over time.  This rise in prices leads to a reduction in purchasing power - which means your money can buy less today than it could yesterday.  

Although it’s extremely difficult to pinpoint a cause (hence the wide disagreement among policymakers and financial pundits) - potential causes of inflation fall into three broad categories:

1. Demand related - this is when prices increase because consumers want to buy more than businesses can supply.  You can think of it as “too many dollars chasing too few goods.”  Also known as “demand-pull,” this is the most common type of inflation and is often the result of governments adding money to the system (i.e. stimulus).  

2. Supply related - this is when prices increase because businesses start producing less.  A common example is when some external factor (i.e. war, natural disaster, pandemic, etc.) leads to decreased production capacity.  Also known as “cost-push,” many argue today’s inflation has been supply-driven due to COVID shutdowns and the war in Ukraine. 

3. Expectation related - this is when prices increase because consumers and businesses expect inflation to be sticky.  A self-fulfilling prophecy - the idea is that more purchases are made today because prices will rise tomorrow, which ironically leads to more price increases.

Interest rates

Interest rates are simply the price of money.  It’s the compensation lenders receive for providing funds and the cost borrowers pay to use the funds. 

Since governments/central banks control the money supply they have significant influence over the level of interest rates.  There are other determinants, however.  

Here’s a simplified overview: 

Interest rate = risk free rate + risk premiums 

1. Risk-free rate - you can think of this as the short-term interest rate targeted by the Federal Reserve (the US central bank aka “the Fed”).  When you hear the Fed raised rates then think of this component.  It’s how much interest you can earn without risk (i.e. insured bank deposits, US treasury bills, etc.) 

2. Risk-premiums - for loans that aren’t risk-free, lenders must receive additional compensation to account for the added risk.  Some examples are the term premium and credit premium.  The term premium relates to the length of the loan.  Short-term loans have less risk and therefore lower interest rates than long-term loans.  This is because it’s much easier to predict what will happen in 1 year than in 5 years.  Risk = uncertainty.  The credit premium relates to the risk of default (i.e borrowers who do not pay back the loan).  If a person or a business has an unfavorable credit history, then lenders will require higher interest rates to account for the greater probability of not getting paid back. 

What it all means 

Now that we’ve defined our terms - let’s connect the two.  Inflation began to increase sharply in 2021 so the Fed has since raised interest rates several times as a combative measure.  This is known as a restrictive monetary policy response. 

The basic idea is that by increasing interest rates (“the price of money”) then both consumers and businesses are less likely to take out new loans.  This is meant to slow spending and give the economy some time for the supply and demand dynamics (discussed above) to rebalance and reduce inflationary pressures.

Higher interest rates should also entice more savings which can further reduce spending and therefore inflation.  

Only time will tell whether increasing interest rates can cure the inflation problem, but we hope our comments have better prepared you for that next headline or conversation that inevitably involves inflation, interest rates, or in all likelihood, both. 

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