Economies across the globe are reeling under record inflation levels. Central banks are now racing to combat this rising tide of inflation by utilizing all the weapons in their arsenal. The Federal Reserve recently hiked its lending rates by 0.75 % or 75 bps. This marks the largest rate hike in almost three decades.
India is not immune to this case of rising inflation. In April, the country’s retail inflation measured as Consumer Price Index (CPI) rose to an eight-year high of 7.79%. This is far from the RBI’s inflation target of 4%. In this article, we will try to analyze why inflation is soaring and the reasons behind rising interest rates. Finally, we will examine the consequences of inflation and high-interest rates on the financial markets.
Why is Inflation Soaring?
The sustained rise in goods and services prices is inflation. This is a common phenomenon that we experience in our daily lives. While rising inflation is necessary for a good, healthy economy. Soaring inflation, like the one we are experiencing today, is detrimental to the economy’s growth. Inflation, if uncontrollable, may lead to an economic slowdown and stagflation.
Numerous factors contribute to a rising inflation rate. Let us examine the two most significant factors that contribute to the recent, record-high inflation that we are experiencing today:
- The COVID-19 pandemic brought the world to a halt. enforced strict lockdown measures to curb the spread of the virus. This resulted in factories shutting down and mass layoffs by businesses to stay afloat. The major global economy link, logistics, also suffered the same fate as the other businesses. As the global supply chains unclog, companies began transferring their rising input prices to the consumer. This, combined with supply-chain disruptions and pent-up demands for goods and services, created the perfect ingredient for demand-driven inflation.
- The War in Ukraine began in February of 2022. In a bid to dissuade Vladimir Putin, the US-led coalition imposed harsh sanctions on Russia. As Russia is a significant commodity powerhouse on the global stage, commodities prices rose on fear of supply shortages. The price of essential commodities like crude oil crossed the ominous $100 price level a week after the invasion. Meanwhile, grain prices soar to a record level. This rise in prices of commodities fed into already-high inflation, resulting in the current record inflation level.
The International Monetary Fund (IMF) has altered their inflation projections due to the conflict in eastern Europe. It has raised its inflation estimates – by 1.8% for developed and 2.8% for developing economies.
Why Are Interest Rates Rising?
It is the directive of central banks to manage inflation. They have access to multiple tools to control inflation, with the benchmark interest rate as their preferred tool. The central bank’s benchmark interest rate is used as a base by banks and other financial institutions to determine their lending rates. If the benchmark rate rises, the interest rate correspondingly rises. Similarly, if the central bank lowers the benchmark rate, lenders also lower their interest rates.
Inflation is generally tackled by removing excess money from the economy. Central banks use the aforementioned benchmark rate as a lever to determine the flow of money within the economy. To control and contain inflation, central banks increase the benchmark lending rate to absorb excess money within the economy. The simple mechanism behind this arrangement goes like this: As central banks raise benchmark rates; lenders raise their interest rates. Borrowers are discouraged from borrowing on account of the high-interest rate. As fewer loans are disbursed, new money entering the economy lowers.
Therefore, we can gather that interest rates rise as central banks increase their benchmark rate to control inflation.
Consequences of Rising Inflation and High-Interest Rate
Rising inflation and high-interest rates impact various financial assets differently. Below, we will consider their impacts on two major asset classes: equities and fixed-income.
- Equities: High-interest rate, typically a consequence of rising inflation, adversely impacts equities. Soaring inflation hurts the present and future earning potential of companies. This is significant considering that most valuation methodologies use a company’s future earnings potential to derive the company’s value. If the future earnings potential declines, the company’s value to investors diminishes. Equities serve as a tool to hedge inflation in the long term. However, in the short-term, share prices fall as inflation rises.
- Fixed-income: Bonds are the most prevalent and widely known form of fixed-income assets. These assets are susceptible to interest rate changes, as high inflation results in high-interest rates. It can be inferred that bonds are also sensitive to inflation. It is a common misunderstanding that rising interest rates are unsuitable for fixed-income assets. Instead, it is the opposite: High-interest rates are good for fixed-income assets. Investors can benefit from rising interest rates by investing in bonds for the short term.
Advantages of Inflation and High Interest Rates
Inflation is feared by everyone, and rightfully so. It decreases your purchasing power, hurts your investment portfolio, raises interest rates, etc. Yet, there are many advantages that we seem to overlook as investors –
- While high-interest rates raise the cost of borrowing, this is particularly beneficial for those investors with significant exposure to fixed-income assets like bonds.
- People tend to save more in times of high-interest rate as the returns earned from a high-interest rate tends to beat returns from risky assets like equities, which do not perform well in an environment of high-interest rate.
- As prices of stocks fall, it presents a good opportunity to value investors, constantly on the prowl for a bargain.
- As inflation diminishes the purchasing power of the people, companies adjust the wages of their employees to retain and attract more workers. As income rises, people can purchase more goods and services. It also benefits the government as taxation income rises.
- If the high inflation results from the demand-pull effect, companies will increase their production to meet the increasing demand. This means hiring more workers, procuring a higher quantity of raw materials, etc. This will overall contribute to the growth of the economy.
Investors can take advantage of these factors if they have the know-how to buy more shares cheaply when the market is down. Inflation may also lead to increased production to meet demand. This will result in more workers being hired and rising wages to attract more workers, contributing to the economy’s overall growth. Thus, inflation can be regarded as the harbinger of growth.
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