Looking at the Link Between Inflation and Interest Rates
In this article, we look at the link between inflation and interest rates, and how they both impact investments. This is particularly relevant to the CII R02 and AF4 exams but may also be useful to those studying for R01, CF1, R04, AF7, R06, or AF5.
Having spent many a year talking about a low-inflation, low-interest rate environment, we’re currently facing the opposite with inflation continuing to grow and the Bank of England’s Monetary Policy Committee (MPC) increasing interest rates in a bid to slow things down.
Monetary policy
Monetary policy attempts to stabilise the economy by controlling interest rates and the supply and availability of money.
Short-term changes in interest rates have been under the control of the Bank of England’s MPC since 1997. They determine what is known as ‘the base rate’ – the rate at which banks can borrow from other banks. SONIA – the Sterling Overnight Indexed Average Rate is the rate at which banks lend to each other. It is thought to be a more accurate representation of the wholesale money markets.
The Bank has an inflation target of keeping the Consumer Prices Index (CPI) at 2%. When the CPI is more than 1% outside of this target in either direction, the Bank’s Governor must send an open letter to the Chancellor explaining how this has come about and how the Bank intends to rectify the situation. Changes to interest rates don’t impact inflation immediately; they take time to filter through the economy. A change in interest rates today is likely to reach inflation somewhere between 1.5 and 2 years ahead.
By increasing the short-term interest rate, monetary policy is said to be tightened to bring inflation down. Longer-term interest rates should rise, we have less money to spend, and businesses invest less and borrow less. Those relying on the interest from investments obviously benefit, providing they’re not tied into a fixed-interest product.
In this article, we look at the link between inflation and interest rates, and how they both impact investments. Share on X
Inflation
Inflation is the rise in prices over a period of time.
In 2017, the CPIH (the CPI including owner occupiers’ housing costs) became the lead measure of inflation used by the ONS. Owner occupiers’ housing costs are not included in the CPI so CPIH is the most comprehensive measure of inflation; although other than including these costs, CPIH is identical to CPI.
Those on fixed incomes are worst affected by inflation as their money will buy less than it used to if prices have gone up. Inflation is particularly significant for people who are invested in fixed-interest securities.
Inflation and investments
With variable-rate deposit accounts, the rate will tend to follow the direction of inflation. As inflation rises, interest rates rise. A real positive return – i.e. a return in excess of inflation and tax – can only be achieved if the rate of interest is greater than the rate of inflation and any tax that may be due. Inflation will reduce the purchasing power of the investor’s capital.
As the coupon on fixed-interest investments and their nominal value remains the same over time – unless they are index-linked – inflation erodes both the interest and the capital. The market value of fixed-interest investments is influenced by changes in inflation. For example, if the rate of inflation is expected to rise, prices will fall as the coupon becomes less attractive in light of increased inflation.
Successful companies tend to increase their profits as inflation rises, which then results in higher dividend payments. Investing in shares is usually seen as a good hedge against inflation.
Interest rates and investments
Having looked at the impact of inflation on investments, let’s now take a look at interest rates.
Rising rates are beneficial for those with variable-rate accounts, while those with fixed-rate deposits miss out.
As the coupon of a fixed-interest investment cannot change, it is the market prices that move in line with interest rates. As rates rise, a fixed coupon becomes less attractive. Demand falls, along with the price.
Equities tend to react badly to rising interest rates as profits fall as consumers are incentivised to save and any borrowings cost more.
Grab the resources you need!
If you’re studying for your CII R02 exam, and you’re wanting a feeling of confidence on exam day, grab our free taster to try out one of Brand Financial Training’s resources for yourself. Click the link to download the R02 mock paper taster now!
Alternatively, you can download the taster for AF4, R01, CF1, R04, AF7, R06, or AF5 if you are preparing for one of those exams.
