This article will explain how the two most important financial variables, inflation and interest rates, impact an individual’s ability to earn and maintain a strong financial position; and will also provide advice on how to navigate those elements and how to create better financial outcomes through smarter decision-making.
Inflation is an increase in the overall price of all products and services available for purchase, which reduces the purchasing power of money over time. It affects everything from what we pay at the grocery store to how much we can save and invest.
- Increases in prices for basic necessities (food, gas, healthcare): Increases in prices for essential items (i.e., food, gasoline, healthcare) cause increased costs for many consumers.
- Reduction of Savings Value: Saving money in low-interest bearing savings accounts will result in decreased savings purchasing power due to the fact that the purchasing power of money decreases faster than savings account earnings.
- Increased Cost of Borrowing Money: Banks and lenders may raise interest rates to combat inflation, making it more costly to borrow money (e.g. loans, mortgages, credit cards).
Protect yourself from inflation by investing in assets that tend to keep pace with or exceed inflation (stocks, real estate).
How Interest Rates Help Manage Inflation
Interest Rates are used by Central Banks (the U.S. Federal Reserve) to regulate inflation in the economy. When inflation increases, the Central Bank may raise interest rates to decrease the amount of money circulating in the economy (thus reducing consumption and investment).
- Increased interest rates: Increase in interest rates causes a rise in the cost of borrowing money (decrease in spending and slow-down in the economy).
- Decrease in interest rates: Lower interest rates decrease the cost of borrowing money (increase in spending and investment, however potential increase in inflation).
- Increase in loan/credit card/mortgage payments: Increased interest rates cause increased payments on loans, credit cards, and mortgages.
Knowing how Central Banks change interest rates can allow you to know when the cost of borrowing money will likely go up/down, and help you decide if you want to take-on debt or refinance your current debt.
Impact of Inflation and Interest Rates on Investments
Inflation and interest rates significantly impact the performance of different investments. Therefore, investors need to understand the implications of inflation and interest rates to develop an effective, diversified investment portfolio that can endure through varying economic conditions.
- Stocks: Historically, stocks have provided higher returns than inflation, however, stocks can be very volatile. Corporate profit margins are affected by inflation and therefore, may negatively affect stock prices.
- Bonds: When interest rates are raised, the prices of existing bonds tend to drop because new bonds are being issued at higher yields, making the older bonds with lower yields less desirable.
- Real Estate: Typically, investments in real estate act as a hedge against inflation since property values generally appreciate with inflation. However, higher interest rates can cause increases in mortgage financing costs and reduce the demand for housing.
Therefore, it is wise for investors to diversify their portfolios to guard themselves against both inflation and the effects of changing interest rates.
Tactics to Mitigate Inflation and Interest Rate Risks
There are many ways that individuals can protect themselves from the dangers of inflation and rising interest rates, and ultimately ensure the maximum preservation of their purchasing power and wealth.
- Invest in assets resistant to inflation: Stocks, real estate and commodities (gold), have historically performed better than inflation.
- Use Bonds with Inflation Protection: Government bonds called Treasury Inflation Protected Securities (TIPS) adjust their principal amounts based on inflation, thereby protecting you from price increases.
- Assess Your Debt Obligations: In a rising interest-rate environment, paying off high-interest debt (such as credit cards) can help to alleviate the burden of debt.
- Monitor Interest Rates: Lock-in lower interest rates on loans or mortgages when interest rates are low, so you can realize greater savings over time.
By using some or all of these tactics, you will be able to protect your finances and adapt to changing economic environments.
Conclusion
Inflation and interest rates are fundamental components of the financial world and directly affect the way in which people earn and spend money. Furthermore, inflation erodes the purchasing power of money, while interest rates determine the cost of borrowing money and the yield on savings and investments. By understanding how inflation and interest rates impact your money, you will be able to make wiser financial decisions and take advantage of opportunities to improve your financial situation.
