Will Raising Interest Rates Stop Inflation?

October 20, 2022

Will Raising Interest Rates Stop Inflation?

Interest rate hikes implemented by the Fed directly target the short end of the yield curve – i.e., overnight interbank lending rates. The idea is that by increasing the rate at which banks lend to each other, other interest rates, including savings rates on bank deposits and financing rates such as mortgages and car loans, will rise in tandem. Higher borrowing costs along with higher savings rates should incentivize saving over spending, helping to reduce demand to bring it more in line with supply. As demand and supply balance out, price pressures should subside, and inflation should moderate. However, other consequences of rate hikes—known to the Fed—also help slow the economy.

First, consider what a rational investor might expect when short-term rates increase. Typically, investors apply a term premium to interest rates, meaning the longer the bond maturity, the higher the interest rate the investor demands. This makes sense as there is more uncertainty over a multi-year period than over the next few months. Remember, the Fed doesn’t have a mechanism to target long-term rates, but they expect their actions on the short end of the yield curve to translate into higher long-term rates.

So how do changes in interest rates affect bond prices? Put simply, higher interest rates equate to lower bond prices and vice versa. If interest rates are increasing, why would an investor lock in yields today, knowing that yields will be higher in the future? An investor certainly wouldn’t want to lock up their money for a long time at today’s interest rates knowing that yields will be higher in the future. For this reason, long-duration bonds get hit much harder when interest rates rise than short-duration bonds. For example, short-term British government bonds, known as Gilts, sit around 10% off their mid-2020 high, while long-dated gilts have lost 54% of their value!

From the impact on bond prices, we should consider the effect on the holders of those bonds. Pension funds usually hold long-term bonds that match assets (bonds owned) against their liabilities (payments owed). Since the payments owed by pension funds extend over multiple decades, it is not uncommon for pension funds to sustain significant losses in times of interest rate increases. We could dig further into the funding status of pensions and what the corporations and government sponsors of those funds must do to fill the gaps, but that is a more detailed discussion. Suffice it to say that corporations need to increase their funding to pensions when rates rise.

How do rising rates affect equity prices? While the daily fluctuations in the prices of stocks can vary significantly based on news releases, earnings reports, or an imbalance of sellers relative to buyers, the fair value of a stock can be summed up as the present value of all future cash flows that stock will generate. To calculate that value, we need to make assumptions about earnings each year in the future and then discount those payments to today’s price using a discount rate generally derived from US treasury rates.

You can think of it this way–if someone promises to pay you a dollar three years in the future and you do not charge them interest, you will lend them a dollar today. But, if you charge some interest, you may only lend them 90 or 95 cents today. The same concept applies to stocks. The higher the interest rates and the longer the time frame before a company generates a cash flow—think dividend-paying blue-chip stocks compared to speculative companies that may not be profitable for several years yet—the lower the stock value today. So, rising interest rates decrease the value of all equities. Still, the impact should be larger on the less profitable / more speculative companies that may not generate cash flows for many years in the future. It’s no surprise that energy stocks that have generated record cash flows in 2022 outperform unprofitable technology companies by a wide margin. It all boils down to cash flows and interest rates.

Higher interest rates also impact homeowners and those with a 401k via the wealth effect. When an asset owner’s value increases, they feel wealthier and are more willing to spend. When the value of their assets decreases, they are less inclined to spend on non-essential items. This impact is one of the ways the Fed is trying to cool demand and slow inflation in the economy. As you would expect, consumer attitudes do not change overnight. Thus, the wealth effect–like monetary policy–works with long and varied lags.

One of the largest contributors to the wealth effect is home prices. As the value of houses increases, homeowners may elect to borrow against the equity in their home to make home improvements, take vacations, put children through college, or something else. Although the expenditures may not seem unreasonable when made, if money is borrowed with variable rates, a rising interest rate environment can make those purchases much more expensive than they appeared just a few months prior. For those who don’t already own a home, the goal of home ownership can become out of reach for many as interest rate hikes make borrowing for a mortgage more expensive. Eventually, either home prices will have to decline, or mortgage rates will have to fall to make housing affordable again. We have already seen home prices rise as mortgage rates have hit their highest levels in over 20 years.

Lastly, we should consider the impact interest rates have on currency markets. If country A raises interest rates faster than country B, or if they set their rate at a higher level than another country, rational investors will want to invest funds in the country with the higher rates—assuming they have a relatively stable currency. This scenario plays out worldwide today, with the United States leading the way in interest rate hikes. As a result of the subsequent cross-border flows, the dollar has strengthened by around 20% this year relative to other major currencies. These currency differentials impact global trade and can help make one producer much more or less than a competitor in another country.

So, the next time you hear that the Fed—or any other central bank around the world, for that matter—is adjusting interest rates, think not just about what that means for short-term interest rates but the impact on all other asset classes, and the impact the move is likely to have on 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.