The Role of Interest Rate Hikes in Mitigating Inflation

October 20, 2022

The Role of Interest Rate Hikes in Mitigating Inflation

Implications for the Yield Curve

The Federal Reserve employs interest rate hikes as a strategic tool to influence the short end of the yield curve, specifically, the overnight interbank lending rates. An increase in these rates is anticipated to impact broader interest rates, such as savings rates on bank deposits and financing rates for mortgages and car loans. The premise is that an elevation in borrowing costs and increased savings rates would encourage saving over spending. This, in turn, helps align demand with supply, consequently reducing price pressures and moderating inflation. Yet, the repercussions of such rate hikes, recognized by the Fed, extend beyond this direct impact, slowing the economy in other ways.

The Investor’s Perspective

An analytical investor, observing a rise in short-term rates, typically applies a term premium to interest rates. In essence, the longer the bond maturity, the higher the interest rate the investor expects. This correlation exists because uncertainty increases over an extended period compared to the subsequent months. The Fed cannot directly control long-term rates, but they anticipate their short-term rate maneuvers will indirectly raise long-term rates.

Influence on Bond Prices

The relationship between interest rates and bond prices is straightforward: higher interest rates correspond to lower bond prices, and vice versa. An investor is unlikely to commit their money for an extended duration at current interest rates, knowing future yields would be higher. Consequently, long-duration bonds face more substantial declines than short-duration bonds when interest rates ascend. This effect is exemplified by short-term British government bonds, known as Gilts, which are approximately 10% lower than their mid-2020 peak, while long-dated Gilts have lost over half their value.

Impact on Bond Holders and Pension Funds

The alteration in bond prices has a direct effect on bondholders. Pension funds, for example, generally hold long-term bonds to match their assets (owned bonds) against liabilities (owed payments). These liabilities extend over several decades; hence, pension funds may endure significant losses during increased interest rates. Corporations sponsoring these funds are then required to increase their pension fund contributions.

Effect on Equity Prices

While daily variations in stock prices are influenced by various factors like news releases, earnings reports, or supply-demand imbalances, the fundamental value of a stock can be summarized as the present value of all future cash flows it will generate. Calculating this value necessitates assumptions about future earnings and using a discount rate derived mainly from US treasury rates. The influence of rising interest rates on the present value of future cash flows is negative, with the impact being larger on less profitable or speculative companies that may not generate cash flows for many years. For instance, profitable energy stocks that have generated record cash flows in 2022 have significantly outperformed unprofitable technology companies.

The Wealth Effect on Homeowners and 401k Holders

The wealth effect refers to changes in consumer behavior based on perceived changes in their wealth. When asset owners perceive an increase in their wealth, they are more likely to spend; conversely, when asset value decreases, discretionary spending decreases. This effect, which operates with long and varied lags, is another tool the Fed employs to curb demand and manage inflation.

Influence on Home Prices

A significant contributor to the wealth effect is home prices. Rising home values encourage homeowners to borrow against their home equity for various expenditures. However, these expenditures may become costly if borrowed at variable rates in a rising interest rate environment. Rising interest rates can make mortgages more expensive for prospective homeowners, potentially pushing homeownership out of reach. This could necessitate a decline in home prices or a fall in mortgage rates to maintain housing affordability.

Impact on Currency Markets

Interest rates can also impact currency markets. If a country raises interest rates more quickly or sets them higher than another country, assuming a stable currency, rational investors would prefer to invest in the country with higher rates. This dynamic has been evident with the United States leading interest rate hikes, causing the dollar to strengthen by about 20% this year relative to other major currencies.

In conclusion, changes in interest rates by the Fed or any other global central bank carry implications beyond short-term rates. These alterations influence a range of asset classes and, ultimately, the global economy.

If you are a Legacy client and have questions, please do not hesitate to contact your Legacy advisor. If you are not a Legacy client and are interested in learning more about our approach to personalized wealth management, please contact us at 920.967.5020 or info@lptrust.com.