Correlation Between Inflation and Interest Rates
It is impossible to avoid hearing about today’s inflation rates, considering the frequency with which they are mentioned in the news. Consequently, interest rates are usually mentioned in the same dialogue. What exactly is the relationship between inflation and interest rates? Having a firm understanding of each of these models as well as how they relate to each other can help you make sound financial decisions going forward.
We’ve all had the opportunity to hear a story from an elderly loved one recounting the cost of milk or bread from decades earlier. It is usually surprising to hear the dollar amount is a fraction of that same product’s cost today. The reason for that is inflation, which is the continuous increase in the price of goods and services over time. Here in the United States, the general policy set by the Federal Reserve is that an inflation increase at a rate of 2% per year is acceptable. Several factors can affect the inflation rate, such as production costs, high demand or monetary policy. Most recently, the United States set a record for the highest inflation rate in 40 years of 7.5%. The pandemic contributed greatly to this increase, as well as higher supply chain costs and employee shortages. This increase was evident in everything from gas to groceries to lumber and utilities. Every single American has noticed and felt the impact of the higher inflation rate.
Interest rates are the percentage and money paid on funds borrowed or saved. The higher the interest rate the more money is added onto the original amount borrowed to pay off the loan. With regard to a savings account, the higher the interest rate, the more is being added to your savings, which is a benefit to the saver. A point to consider is if the interest rate is fixed or variable. Fixed rate interest will secure a rate that will remain unchanged, whereas a variable rate follows market rates. Fixed rates are typically applied to auto or mortgage loans and variable rates are utilized for credit card loans.
The relationship between inflation and interest rates usually go hand in hand. If inflation increases, interest rates do as well. This tactic is implemented in an effort to encourage saving money, rather than spending. At the same token, financial institutions require higher rates to lend funds when the risk is higher. In uncommon situations, such as the pandemic, the government may take drastic measures to boost the economy, as it did by slashing interest rates to 0%. The Federal Reserve was trying to assist the crashing economy to encourage all those that had lost jobs and were hesitant to spend money.
As the nation’s central bank, the Federal Reserve leverages economic growth by lowering and raising the interest rate. When it is lower and less expensive to borrow funds, it stimulates businesses to grow and people to spend. The opposite is also true and the Federal Reserve will increase interest rates to dissuade spending when necessary.
As a potential borrower, pay close attention to interest rates. Even half a percent difference over the course of a thirty-year mortgage can add up to tens of thousands depending on the purchase price. You may want to reconsider your timing and get multiple quotes. As a saver, the ideal is to have your money in a mutual fund, investment, ETF etc. that will earn more than the general inflation rate to avoid losing money over time.
Determining the Difference Between a Bear and A Bull Market
As an investor, you’ve come to realize there are several factors that affect investments, and one of the most relevant and referred to is the type of market an investor is operating in. Knowing if the current situation is a Bull market or a Bear market can have a significant impact on an investor’s strategy. Let’s determine the difference between the two types.
A Bull market indicates that the market overall is rising, positive and businesses are profiting. During a Bull market the expectation is that the stock market will continue to rise. The U.S. Securities and Exchange Commission has a clear definition for a Bull market which states that a Bull market is a period of time in which there is an increase of at least 20% in broad based index funds for at least 2 months. While this may seem extreme, it is a true sign that the economy is doing great. A time frame we can revert to that is documented as a Bull market started in March 2009 and continued for several years, eventually reaching levels of growth topping 500%.
A Bear market, on the other hand, as you may have guessed, is the opposite. In a Bear market, there will be consistent decreases with negative outlooks and failed businesses. The U.S. Securities and Exchange Commission’s definition of a Bear market is a period of time defined by a market drop of 20% over a two-month period. Well known Bear market time periods were the Great Depression and Great Recession. Both time periods exceeded the 20% definition of a Bear market and at some points even reached 50% losses. The negative effects of these Bear market periods were felt for much longer than just during the defined time.
There are other factors that tie into these types of markets. GDP, or gross domestic product, for instance, is a reliable sign of the markets. If the GDP is rising, usually a sign of consumer confidence, a Bull market is usually in play. The same is true in the reverse scenario. If consumers are spending less money, most likely a Bear market will present itself. Unemployment rates are another great indicator of market trends. When unemployment is low, businesses are prospering and people are working, which leads the economy to a Bull market. If unemployment rates are high, businesses are laying off employees and less people have funds to spend on goods and services, most likely resulting in a Bear market. Another consideration is stock market trends. When people are confident in the market, prices will rise and be indicative of a Bull market. When prices continuously decrease, consumer confidence is down, and a Bear market could be in the foreseeable future.
As an investor, analyzing and determining the type of market currently presented is crucial before deciding short term financial decisions. If working in a Bull market, an investor would consider profiting from the continued strength and rise of the market, therefore apply a long-term investment strategy. In a Bear market, short term is the way to go, often selling shares with the plan to buy them again at a lower price.
Overall, investing in both types of markets is a risk. Long term, the stock market average has continuously risen throughout the past century, even with various Bull and Bear markets throughout. As a rule of thumb, invest according to your person risk tolerance and know that the longer the time invested, the better your chances of profiting.