Inflation and Interest Rates

Inflation has exceeded historical averages for several months in a row now. The Federal Reserve plans on continuing to increase interest rates throughout 2022. To better understand how and why interest rates increase, let’s examine the basics.

Interest rates are stated in nominal terms. Which basically just means that a nominal yield includes the real yield and other risk factors such as: inflation, default, and maturity. Since our domestic markets are so efficient interest rates began increasing even before the Fed announced its first-rate hike. As inflation rises, bonds can become less attractive until the rates increase to a more attractive level. Maturity is also important to understand because under normal circumstances, the longer the maturity, the higher the yield. If long-term bonds rates fall below short-term bond rates, this is a sign to investors that the economy may slow down, and a recession is coming. The reason this is the belief is because people are moving their assets to “safer” assets. Shorter term bonds are generally lower risk then long-term bonds, that’s because the longer the time a company or government must borrow the money, the more risk that can happen over that time period.

The most important thing to do when markets are volatile, and inflation is high is to not panic. Though it has been quite some time since we’ve experienced high inflation, we have been through it before. Over the next several months you will continue to hear a lot of negatives in the news about inflation. The best thing to do is tune it out and trust the plan you have in place. If you do not have a plan, there is no better time than now to get one!