General Trading Education

Interest Rates and Inflation – How are They Related?

Interest rates and inflation often go hand in hand when it comes to discussing the economy. Their relationship is a complicated one that comes with a lot of yin and yang. When interest rates are held low for a long period of time, it puts more money into the market and increases the chance of inflation. The same goes for the inverse. When interest rates are held high it puts a strain on money in the market, thus lowering inflation.

What Factors Influence Interest Rates and Inflation?

Demand for Money – This can typically be seen in growing economies but can also be seen in established ones. Demand for money refers to the needs of the production and manufacturing sectors. When an economy is growing, these sectors often must expand rapidly to keep up consumer demand. These expanding sectors now need money to pay for the expansion, which often leads to them borrowing money. You also have consumers borrowing money to buy things like goods, services, housing, etc. All this borrowing and high demand for money causes interest rates to rise because there simply is not a large enough supply to keep up with it.

Supply of Money – This is something we are seeing in the US right now as a result of the Covid-19 pandemic. Consumers were locked in their houses for over a year while production and manufacturing slowed. Now things are opening back up and consumers have a thirst to make up for lost time, plus leftover government stimulus checks, creating a lot of money in the market. People want to spend and the economy doesn’t have the manufacturing and supply chain depth to keep up with it. When the market is flooded with money like this, we often see inflation rates start to skyrocket and interest rates come down because there is no demand for money, people already have it. We are certainly seeing that right now with federal interest rates being held near zero, while target inflation is up to 3.4%

Government Borrowing and Deficit – This occurs when the government is spending more money than it brings in, which has been the case in the US for years…just look at the budget deficit. To make up for this deficit, the government will borrow money, which in turn will impact interest rates by causing them to go higher. You will often see an uptick in bond yields too, which will lead to more money going towards bonds. Bonds are seen as a relatively safe investment and when yields are high it makes for a profitable and less risky investment.

Other factors that can contribute to fluctuation in interest rates and inflation are the global economy and central banks. These two factors are more pronounced during times of global economic strife, like what we are seeing now with the fallout of the Covid-19 pandemic. The balance of the global economy was thrown off and central banks need to work together to steer the ship straight. While there are more factors that can impact interest rates and inflation, these 5 are the most popular and largest.

What Happens When Interest Rates Rise?

When interest rates rise, it puts a squeeze on the supply of money in the market, therefore causing inflation to trend down. This also puts a squeeze on spending both at a corporate and consumer level. Often times, this squeeze on spending will drive company stock prices down due to lack of earnings. The driving factor behind a rise in interest rates is supply and demand. When there is a larger demand for money in the market it causes interest rates to rise creating a ripple effect across the economy.

How are Interest Rates and Inflation Related?

Interest rates and inflation are related through the inverse property. A large supply of money, like we are seeing now, coupled with low interest rates leads to consumers ramping up their spending, causing a rise in inflation. The same goes for the opposite scenario. When interest rates are high, it creates a lower supply of money in the market, thus curbing spending and in turn lowering inflation rates. It is important to remember that these two are inverse and interest rates do not rise with inflation. What it boils down to is if interest rates are high, inflation is low and if interest rates are low, inflation is high.

One of the determining factors behind these fluctuations in interest rates and inflation is the Federal Reserve, or Fed. The Fed will monitor inflation and interest rates and try to influence them in the best way possible for the health and growth of the economy. The Fed will determine when it is best to raise or lower the Fed funds rate (interest rates) based on a variety of factors. The ability to influence inflation allows the Fed to control the money supply as they see fit, which can influence everything from target employment rates, economic growth, housing, consumer pricing and much more. This balancing act between the Fed, interest rates, and inflation is the backbone to the US economy and one of the major keys to its overall stability.

What Happens When Inflation Rises?

When the inflation rate rises, you are looking at a higher cost for almost everything, starting with raw materials. When the cost of raw materials goes up, the cost for everything made from those raw materials, like consumer products, goes up too. When the prices for consumer goods go up, you also likely have a call for an increase in worker wages to keep up with the higher cost of living. You also will see an increase in consumer buying power and a devaluation of the dollar or other currency. Consumers feel more likely to spend because they have more capital. This devaluation of the dollar often leads to consumers investing in commodities like gold and silver because they feel the value of those will hold over time in comparison to a weakening dollar.

In the public eye, inflation generally has a poor connotation, however there are some positives that can arise from it. Inflation can also be a sign of economic expansion and a growing economy as consumers are flocking to spend money on goods and services. This rapid expansion of the national economy also creates more jobs to keep pace, thus lowering unemployment numbers. You may also see a decrease in individual debt as consumers are able to pay off their loans quicker. So, the next time you hear the word inflation, remember that it isn’t necessarily a bad thing.

Is Inflation Good or Bad for Stocks?

inflation is generally considered bad for stocks. For starters, it increases borrowing costs and the costs of raw materials and labor. Inflation also lowers standard of living rates across the country leaving investors with less money to invest because they are spending it on their everyday cost of living. Another strain inflation puts on stocks is that it dampens earnings expectations, which in turn puts downward pressure on stocks leading to a negative impact on the stock market.

How Can RJO Futures Help?

Our experienced Senior Market Strategists are well equipped to help each investor navigate periods of inflation within the constraints of each investor’s needs and risk capacity. In addition, we have compiled this RJO Futures Special Report: Inflation, How Much is Too Much? to help you understand and combat inflation. Inflation can be scary, but can also present a unique investing opportunity, to explore your options please reach out to one of our Senior Market Strategists and they will be glad to assist you!