Central banks, such as the Bank of England, have the power to influence base interest rates to manage inflation, aiming to maintain price stability and control inflation within a target range.
When inflation is high, the purchasing power of money decreases, and central banks may raise interest rates in an effort to reduce spending and borrowing. By contrast, if the economy is sluggish, central banks may lower interest rates to encourage borrowing and spending, boosting economic activity. Monetary policy has historically been an effective tool to curb inflation caused by bank lending, however interest rates are arguably more of a blunt tool against inflation that is fiscally led by government incentive.
Interest rate changes have contrasting effects on savers, investors, and borrowers. For savers and investors, higher interest rates are beneficial as they result in increased returns on savings and fixed-income investments, allowing for more effective compounding or higher supplementary incomes. For borrowers, higher interest rates result in more expensive borrowing costs, such as higher housing costs and increased interest payments on loans and credit card balances. This in turn can exacerbate other cost-of-living related pressures.
Taking housing costs as an example; when interest rates rise, so do mortgage rates. Higher mortgage rates often translate into higher monthly mortgage payments. This affects both prospective new home buyers, and existing mortgage holders who may either be on variable rate deals, are looking to refinance, or are approaching the end of short-term deals.
Rental prices are determined by supply and demand dynamics in the housing market, and while interest rate changes do not have a direct impact on rents, they do impact them indirectly. Landlords who face higher mortgage payments against rental properties may increase tenant rents to meet their increased liabilities. Also, as higher interest rates make home ownership less affordable, some choose to continue renting. This increases demand for rental properties, which drives up rental prices.
Changes in interest rates also affect bond markets. When interest rates rise, the coupon yield on existing bonds, such as UK Gilts, which were issued at lower rates become less attractive, leading to a decrease in bond prices. Conversely, when interest rates fall, prices for bonds issued at higher rates tend to rise as the yield becomes more attractive.
There is still another converse relationship at play here though, as when a bond’s price falls the effective return when holding it until its scheduled maturity date (known as its yield to maturity) can become more attractive.
To both combat inflation and provide a real yield above it, governments and companies also sometimes issue inflation-linked bonds. These investments adjust their returns based on changes in inflation, helping investors protect their purchasing power over longer durations.
While it is true that higher rates bring opportunity for higher yields for investors, the dynamics affecting central bank decisions are ever-fluid, and market consensus currently expects rates to fall once inflation is deemed to be under control. When assessing the impact of interest rate changes on investments, it is important to consider reinvestment risk, duration, and credit worthiness as all can affect a product’s suitability to investor needs.
Reinvestment risk refers to the possibility that future investment returns will be lower due to reinvesting at lower interest rates. For example, if a bond with a high interest rate matures or is sold, the investor may struggle to find a similarly attractive investment opportunity should interest rates plateau or fall.
Duration measures an investment's sensitivity to interest rate changes. For example, bonds with longer durations tend to be more sensitive to interest rate fluctuations, experiencing greater price changes.
Investors must also consider the potential impact that interest rate changes have on the credit worthiness of the issuers of their fixed-interest investments. Those issuers also have to contend with reinvestment and duration risks themselves and should these not be effectively managed then there may be risks such as them defaulting on a scheduled coupon payment, or a downgrading of their credit rating.
Summary
The relationship between interest rates and inflation drives central banks to adjust rates to manage economic conditions. The below linked IMF blog post takes a deeper look at the relationships that fiscal and monetary policy hold with inflation.
https://www.imf.org/en/Blogs/Articles/2022/11/21/how-fiscal-restraint-can-help-fight-inflation
In addition to the direct impact on asset prices, interest rate moves also have significant implications for the public, affecting savers, borrowers, homeowners, and renters in different ways, typically benefitting savers and burdening borrowers. It is important for individuals to understand how interest rate changes impact them. Therefore, it is recommended that investors work with their investment professional to evaluate their circumstances and explore the options available to them to ensure their assets continue to meet their liabilities.
The value of an investment and the income from it can fall as well as rise, and investors may not receive back the amount they invest. Past performance is not a guide to the future.