How Does Inflation Impact Interest Rates And Bonds

By 
Tim Clayton
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

US inflation historic chart

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.

Federal Funds Effective Rate

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…

10-year Long-Term Government Bond Yields

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:

Currency Pegging

What is Currency Pegging and Is It Healthy for the Economy?

Various countries and governments worldwide have been seeking to stabilize their countries’ economies by pegging their domestic currency to a

Economic Indicators

Underrated And Overrated Economic Indicators

Today, we will look at what I think are the three most useless economic indicators that investors and traders should

interest rates

How Does Inflation Impact Interest Rates And Bonds

Inflation, interest rates, and bonds are interconnected financial concepts that play a significant role in any economy. To understand their

trade deficit

Trade Account: How Does it impact currencies?

A fundamental building block of currency valuations Although data can receive little attention for extended periods, trade performance is a

libor

What Is The Libor Rate And How Does It Impact Currency Rates?

The London Interbank Offered Rate (LIBOR) plays a key role in the global currency economy and major historical currency events.

International Invoicing for SME's

International Invoicing for SMEs

The UK’s small and medium enterprises (SMEs) increasingly trade globally. Foreign trade allows them to broaden their reach, create opportunities

Cost of Living in Switzerland Vs UK

Cost of Living in Switzerland Vs UK

The UK and Switzerland are both exceptional countries that offer promising prospects for anyone looking to relocate. However, when it

Cost Of Living In Spain Vs UK

Cost Of Living In Spain Vs UK

When it comes to the cost of living in Spain versus the UK, it’s clear that the Spanish know how

Cost Of Living In New Zealand Vs USA

Cost Of Living In New Zealand Vs USA

Between New Zealand and the United States of America, the cost of living is cheaper by up to 22% in

Cost Of Living In Canada Vs UK

Cost Of Living In Canada Vs UK

Are you thinking about relocating to Canada or the UK and curious how much it will cost to live there?

Cost Of Living In Australia Vs Canada

Cost of Living in Australia Vs Canada

Whether you prefer the Land Down Under or the Great White North, both Australia and Canada offer a high standard

Cost Of Living In Australia Vs UK

Cost Of Living In Australia Vs UK

Australia and the UK offer compelling relocation options owing to their top-notch educational systems, high standards of living, and diverse

cost of living Spain vs USA

Cost Of Living In Spain Vs USA

The United States of America and Spain are among the best places to live in the world, but they are

cost of living France vs USA

Cost Of Living In France Vs USA

France is a treasure mine of history, stunning architecture, and delectable gastronomy. Living there comes at a steep price, which

cost of living australia vs US

Cost Of Living In Australia Vs US

The United States and Australia are two countries on the list of attractive destinations for international migrants. There are several

Cost of Living in Portugal vs USA

Cost of Living in Portugal vs USA

Depending on your personal needs and preferences, living in Portugal or the United States can be a wonderful experience. Although

Cost of living in Colorado vs Texas

Cost of living in Colorado vs Texas

Cowboys and rodeos, delicious food and beer served in generous amounts, and a Wild West heritage — Colorado and Texas

Economic Calendar UK

The table below, detailing the most important economic events that impact the economy and currency rates in 2023, can help

Brexit: Timeline, Impact and Aftermath

It’s January 31, 2023 and it’s been three years since the momentous occasion of Brexit. The United Kingdom’s departure from

Terrorism’s Impact on Economy

When there are terrorist attacks, globally, and they are making headlines , shocking the whole free world, many investors, workers,

Cost of living Florida vs California

Cost of living in Florida vs California

If you love the tropical climate and are keen on living the laidback beach life, you’re probably debating moving to

Cost of Living New Zealand Vs Australia

Cost Of Living In New Zealand Vs Australia

Australia and New Zealand are among the most popular choices for those looking to move to a country with a

technical-analysis

Technical Analysis for Beginners

If you understand the fundamentals of foreign exchange rates like economic indicators and wish to be able to do comprehensive

South African Emigration Patterns and Their Impact on the South African Economy

Recently it has become popular for the white population of South Africa to emigrate to other countries. Given that the

Major Historical & Economical Events Which Impacted Currency Rates

As long as people have been using money, economic events have had a major impact on humanity. History has been

Oil Prices Impact on Currency Rates

Oil Prices Impact on Currency Rates and Economy

Changes in oil prices are a vital component for the global economy given the impact on both growth and inflation.