Interest rates

The relationship between inflation and interest rates

by Beau Kemp, CFP

As inflation continues to rise above our historical average, the Fed continues to plan to raise interest rates throughout 2022. To better understand how and why interest rates will rise, we need to look at the basics.

Interest rates are expressed in nominal terms. A nominal return includes the real return and the risk premia for the following: inflation, default, liquidity and maturity. Markets are very efficient, which is why interest rates started to rise before the Fed’s first interest rate hike. As expected inflation rises, bonds may become less attractive until investors see the yield increase.

The maturity premium is important because it can act as a leading indicator of the direction the economy is taking. Under normal circumstances, the longer the maturity, the higher the yield on a bond. If the yield curve inverts, it means that longer-maturity bonds are yielding less than shorter-maturity bonds. When this happens, investors tend to think the economy is going to slow down and a recession is approaching. Historically, this has often been the case, but that is not all. Also, if you think you are going to time the market after a reversal, chances are you will lose that game. There have been times in the past when the recession didn’t happen for a few years after the reversal, while other times it happened right away (or not at all!).

You may be wondering if this is all about you. A major impact is for anyone in the market to buy a home. Mortgage rates tend to rise as the 10-year Treasury rises. This may force you to buy a cheaper house because your monthly expenses will be higher than expected.

If you’re still in the investment accumulation phase, none of this should change your long-term plan. You probably invest in index funds in your retirement account, and this strategy works great when you stick with it. For the retiree in the disbursement phase, the rise in interest rates will improve your short-term investments. Inflation will have a negative effect, but as mentioned in the video, inflation does not affect retirees as much as one might think.

As always, the most important thing an investor can do is not to panic. It’s not new. We have been through highly inflationary environments before. You will likely hear a lot of negativity in the news as well as from your peers. The best thing you can do is fix this and trust the plan in place.

About the Author: Beau Kemp, CFP®, RMA®

Beau Kemp, CFP®, RMA®, is a Financial Planner at Sensible Money. He started as an intern while finishing his last semester at Northern Arizona University and since then he has enjoyed seeing the impact of a financial plan on a person’s life.