Rising Inflation and Interest Rates: What That Means for You
Written by: Caleb Tucker, CFA®, Director of Portfolio Strategy
Mortgage interest rates hit an all-time high earlier this year, and while the numbers have quieted down a bit since then, all signs point to higher interest rates going forward. In fact, the Federal Reserve has already indicated that it plans to do six more interest rate hikes in 2022 alone. [1] And though higher interest rates are often a double-edged sword for consumers, inflation is not.
Inflation is expected to stay above 5.5% for the rest of the year. [2] Over the past two decades, Americans have become accustomed to inflation hovering around 2%. Thus, the combination of rising interest rates and inflation will impact almost everyone in one way or another, but there are a few key points of concern that can help you understand what these changes really mean for you.
Rising Inflation: Less Purchasing Power, Higher Costs
Rising inflation means that every dollar you make loses value. So, to put things in a clearer perspective, an annual inflation rate of 2% means that your dollars are worth 2% less than they were one year prior. Therefore, rising inflation makes it harder and harder to cover rising costs and find investment or savings vehicles that can outpace the declining value of the dollar.
This also brings up one of the most overt signs of ballooning inflation: the increased cost of goods. Higher costs can have an impact on both your short and long-term financial plan, as you may have to completely reconfigure your budget just to accommodate ever-increasing prices. Additionally, you will need to ensure that your investments are allocated in a way that still supports your long-term goals and spending plan.
Inflation creates challenges for people who have significant investments that are not intended to grow substantially (like bonds or savings accounts). Thus, investors need to think about the erosion of their purchasing power and how their investments can help them keep up. For example, let’s say you have $100,000 in a savings account with an average APY of 3%. If inflation remains higher than 5.5% for the foreseeable future, which is very unlikely but not impossible, it would mean that the value of the money in your account would actually go down by at least 2.5% each year.
Fortunately, one of the best hedges against long-term inflation is owning equities. Equities generally refer to any stake in a for-profit entity, which for most investors is achieved through investing in the stock market. Why do equities help curb the impact of high inflation? Because companies can increase prices and grow their earnings over time, even with rising inflation. So, as long as the companies are delivering value and markets are trending higher, then you have a better chance of outpacing inflation with equities than you would with low-risk, low-yield investments. In short, equities are the best way to combat inflation through investments due to the fact that companies can offset the effects of inflation by charging more, which allows revenues to increase over time and outpace inflation.
Rising Interest Rates: A Double-Edged Sword
When interest rates go up, it causes volatility for investors with fixed-income portfolios. But over the long-term, these rising interest rates can create higher returns for those same portfolios. This happens when maturing bonds are reinvested into new bonds with higher yields.
Higher interest rates also impact the stock market at large. When rates move higher, owning higher-quality companies becomes particularly important. This is because higher interest rates increase borrowing costs for everyone, including businesses. Businesses that are not overextended and have high quality cash flow can withstand higher interest rates better, making them safer and more lucrative options for investors.
Rising interest rates will also have a negative impact on bond markets and equity markets over the short term. For stocks, it can cause some volatility because of the higher borrowing costs. But just because rates move higher does not mean that the stock market has to go down over the long-term; it may just be more volatile as rates change.
At the individual level, the rising interest rates mean that new loans come with higher borrowing costs. This often precedes the positive aspects, turning many people away from the housing market or loans in general. However, eventually, interest-bearing investments (savings accounts, CDs, bonds, etc) will give back better yields as interest rates increase. Loan costs versus investment yields are the two most obvious signs that rising interest rates can be both a benefit and a drawback for the average consumer.
The Bottom Line
Rising inflation has virtually no positive effects on you or your budget. While it often coincides with increased spending and production (which stimulate the overall economy), inflation makes it harder to manage your financial plan over the short and long term. Alternatively, rising interest rates can have both positive and negative effects on your finances. The short-term losses and volatility eventually subside, allowing investors to benefit from being patient. Additionally, borrowing costs may increase with interest rates, but with time, the investment yields will increase as well.
Navigating both rising inflation and interest rates can be complex. For this reason, it is extremely important to have a financial plan in place and ensure that your investments reflect your long-term goals. If you are having difficulty devising a sound financial plan, consider discussing your plan with an advisor. At Merit, our advisors are well-versed in the effects of both rising inflation and interest rates. We can help you build a financial plan that makes sense and moves you closer to meeting your goals, even in the face of larger economic changes.
To learn even more about rising inflation and interest rates or to get one-on-one help with your financial plan, be sure to contact Merit Financial Advisors today!
Sources:
Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Merit Financial Group, LLC, an SEC-registered investment adviser. Merit Financial Group, LLC and Merit Financial Advisors are separate entities from LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.