How Does Inflation Impact Interest Rates And Bonds

By Last Edited Mar 21, 2023

Inflation, interest rates, and bonds are interconnected financial concepts that play a significant role in any economy. To understand their relationship, it’s essential to recognize the factors that drive inflation and the tools central banks employ to manage it. If you want to get the full picture and be able to forecast future currency rates accurately, we recommend you would also check our technical analysis guide for beginners.

The Growth of Demand and Inflation

The world’s population continues to expand, and with it comes an increase in needs and desires. As people require access to housing, healthcare, and transportation, they also seek new experiences and opportunities for travel and exploration. This heightened demand for goods and services can increase prices, contributing to inflation.

Inflation is a natural process rooted in the growing global population and rising demand for goods and services. As people accumulate wealth, they consume more, fueling the demand increase. To better comprehend inflation’s impact, it’s crucial to understand its two primary types: demand-pull and cost-push.

Demand-Pull Inflation

Demand-pull inflation occurs when the demand for goods and services outpaces supply, leading to higher prices. This type of inflation is often driven by factors such as strong economic growth, increased consumer spending, and a rise in disposable income. As the economy expands and people become wealthier, their consumption patterns change, contributing to demand-pull inflation.

Cost-Push Inflation

On the other hand, cost-push inflation results from increased production costs that drive up the prices of goods and services. A common cause of cost-push inflation is rising energy prices, particularly oil, which can significantly impact the cost of manufacturing, transportation, and other essential services. This type of inflation can also result from supply-side disruptions, such as natural disasters, labor strikes, or geopolitical events, which lead to shortages and higher costs.

Central Banks and Inflation Management

In every country, the Central Bank (FED in the US) will seek to avoid deflation and keep inflation under control. Indeed too much inflation (especially cost-push) leads to an unstable environment where people’s purchasing power gets affected and where disparities between rich and poor get bigger. So usually, developed countries’ central banks will target an inflation rate equal to 2%. In order to achieve this monetary policy objective, central banks will make use of various tools, including the most important one: interest rates.

How Inflation Influences The Interest Rates

So we all want to buy cheap and sell expensive. In the fixed-income world, we want to borrow at a low rate and earn savings when interest rates are high. Therefore, the central bank will increase interest rates whenever inflation shoots up. As interest rates get an increase, we would be incentivized to earn on savings rather than borrow (no one wants to pay high-interest rates). As a logical result, people save money and borrow less – which decreases the money supply in the economy. Therefore, with less money flowing, money becomes more scarce and, therefore, more valuable, which reduces inflation.

Looking at the opposite scenario, let’s think that a country is getting into deflation. The first thing to say is that deflation is an extremely dangerous process that needs to be avoided at all costs. If you think that assets prices are going down, you do not invest and keep your money. As people behave in the same way, demand for goods and services decreases, and deflation gets even worse. In other words, deflation gets countries into vicious circles. The central bank would reduce interest rates to incentivize spending and investment through borrowing to avoid deflation.

So based on the economy’s health and future prospect, central banks will make use of the interest rates instrument in order to achieve target inflation rates.

As this process goes by, various financial instruments’ prices get affected. So let’s see how Government Bonds prices behave.

How Inflation Influences The Government Bonds

One of the instruments raised by governments to finance their budgets is bonds. Government Bonds are debt securities carrying a coupon payment (interest payment) that is in line with the country’s perceived level of inflation and default risk. As we are not tackling credit risk, we will focus on risk-free inflation-related risk for now. So let’s say that we are in December 2023, and the US Government issues a 10-year risk-free bond with a fixed coupon of 2%. In other words, lenders will receive a yearly interest of 2% which will make up for the year’s expected inflation in the US.

Now let’s imagine that by 2024, inflation will shoot up, and the US Government will increase interest rates. As an investor, you receive a 2% interest rate within an environment where interest rates have increased and inflation is rising. So the debt security that you own pays 2% when based on the current macroeconomic context, you would have expected to earn more than that. Obviously, and given this, your security’s value will decrease.

In the same way, should interest rates decrease, you would receive more interest than expected, and the value of your security would go up.

So, as a rule of thumb, Government Bonds’ value goes up when interest rates go down and vice versa. This being said, Government Bonds’ prices are not solely affected by the risk-free rate. For most countries, credit risk is the main driver of debt securities’ prices…

Summary

In summary, the relationship between inflation, interest rates, and government bonds is complex but can be understood through the basic principles of supply and demand. Inflation is a natural process that occurs as the global population grows and people’s needs increase. It can be caused by increased demand (demand-pull inflation) or costs (cost-push inflation). Central banks, such as the US FED, seek to control inflation by adjusting interest rates.

When inflation increases, interest rates go up, incentivising people to save money and borrow less, reducing the supply of money and decreasing inflation. On the other hand, when a country is experiencing deflation, interest rates are reduced to incentivize borrowing and spending to avoid a deflationary spiral. Government bonds are debt securities issued by governments to finance their budgets, and their prices are affected by the changes in interest rates set by the central bank.

More similar posts: