The Investment Series: Inflation and Interest Rates
With high inflation comes high interest rates — reference to the iconic Spiderman quote.
Inflation is the hot topic right now and the central banks across the world are reacting. In my last article ‘Economic Recovery and Inflation’, I covered what inflation is and how it is measured, so I won’t discuss it at great length here. But in a nutshell, it is the rate at which prices for goods and services in an economy increase over time. In the previous article, the main inflationary pressure was the impact of restarting the global economy post-pandemic. Today, the pressures on inflation are wider ranging.
WHAT IS IMPACTING INFLATION TODAY?
Recent data from April 2022 has shown 40-year highs of 9% in the UK and 8.6% in the US (using the CPI measure). The Eurozone has also recorded a record high of 8.1% in May 2022. These numbers are far from the typical central bank target of 2%. So, the question here is: what is causing this inflation?
The answer: several factors. Globally, supply chain issues persisting off the back of the pandemic, Covid-19 infection rate flare ups and now worsened by the war in Ukraine which has impacted commodities such as oil, natural gas and wheat. Oil being a major player in the upward pressure on fuel prices.
In the UK, there are food price rises — anticipated to soar as high as 15% this summer — thanks in part to the war in Ukraine, Chinese lockdowns and export bans in Indonesia and China (see full article from the Guardian).
In the US, in addition to the above, commentators also point to the record low levels of unemployment at 3.6% as a contributing factor. One may wonder what low unemployment, i.e. less people out of work, does for inflation, but this is an inflationary sign of labour market shortages. Supply and demand economics at its finest, and a troubling trade off for central bankers (tune into the 16 June FT News Briefing episode for a discussion of this).
Indeed inflation is a global problem posing issues not just for the policymakers, but for the everyday consumer — hence the UK’s cost of living crisis.
TACKILING INFLATON WITH INTEREST RATES
The staple defence to high inflation is tight monetary policy — in layman's terms, increasing interest rates. A fairly simple economic solution, at least in theory.
What does this mean you might ask?
The interest rate is the cost of borrowing money. The base/benchmark rate that central banks set will ultimately dictate the cost of money for institutional borrowers and consumer spenders like you and I. In the pursuit of taming inflation, central banks will make money more expensive to (i) encourage less spending/borrowing and (ii) encourage more saving. This is why you may have seen the interest rates on some savings products going up recently. In doing so, less is bought and sold in the economy — something economists refer to as the velocity of circulation. But again, simply a supply and demand phenomena. People buying less puts downward pressure on prices.
Interest rate hikes are therefore very much in fashion. The US central bank, the Federal Reserve (the Fed) recently announced a benchmark rate hike of 0.75 percentage points, with further increases likely. The Bank of England’s Monetary Policy Committee also voted to raise rates again by 0.25 percentage points to 1.25% (the Guardian has an interesting article on what this will mean for us). This trend was followed by the Swiss National Bank raising its own policy rate by 0.5 percentage points — the first increase in 15 years.
With a current base interest rate of -0.5% in the Eurozone, the spotlight is now on the European Central Bank (the ECB) to follow suit. The ECB will next meet to decide on this on 21 July 2022. There are hints of a 0.25 percentage point hike, this would be the first for more than 11 years (read more here).
BAD NEWS FOR EQUITIES
For my fellow stock lovers — it has not been great. With US stocks already in bear market territory, the S&P 500 index dropped 3.2% and the Nasdaq 4.1% on Thursday following the Fed’s rate announcement. The Dow Jones Industrial Average fell more than 2.4%, pushing it below 30,000 points for the first time since January 2021. The same sentiment followed in the UK with the FTSE 100 falling more than 3%.
What is seemingly clear here is that stocks do not like interest rate rises. Justifiably so, since the increase in the cost of borrowing money is a greater business cost. This signals lower earnings for firms who also have to grapple with lower consumer demand (people spending less).
To close, the next six months to a year will likely be a troubling time on many fronts. With the World Bank recently lowering its global economic forecast for 2022 to 2.9% (down from 4.1%), the stagnation buzzword has already started to make some scary appearances in the financial press.
Stagnation is a period of low economic growth and high inflation — not good.
If the stock market has taught us anything in the past, it is that negative fluctuations are a natural occurrence. And there have been several, namely the .Com bubble (2000), the global financial crash (2007) and the Covid-19 pandemic (2020). Painfully optimistic as ever, I’m hoping for the best.
As always, I must stress that this article is not investing advice — I am not an expert. If you are interested in investing in the markets but not sure when, where or how to start, please seek professional advice. All investments fall as well as rise in value, so you could get back less than you invest.