Inflation and Interest Rates

Inflation and interest rates have the ability to change the returns on our investments, but do we understand how they affect them or pay a lot of attention to them?

(Image source: flickr.com, Chris Butterworth)

Inflation is the rate at which we have to discount our returns to get our real rate of return. For example, if we had a 10% return on our investment, but an inflation rate of 10% over the same amount of time, we would have the same purchasing power as before, so our real rate of return is 0. If we made the same return but the inflation rate is 5%, we would have a real rate of return of 110/105 - 1 =4.76%, or you can use 10-5 = 5%, instead, which gives a close estimate. But if inflation is higher than your rate of return, then you are actually losing purchasing power, which is why putting your savings in the bank at a paltry interest rate, far below that of inflation, is causing you to "lose" money.

If you want to see the inflation rate, you can look here. For the past year or so, the inflation rate has been negative, so just keeping cash on hand equates to a positive real rate of return.

Interest rates in turn are affected by inflation rate. If there is a high inflation rate, investors will want a higher nominal return on their bonds to maintain their real return. The prices of bond will therefore decline until investors get the return they think is fair. And if there are higher interest rates in the bond market, the rate at which future cash flows/profits from the companies will be discounted will increase, leading to lower current prices for them. This is how interest rates and inflation rates directly and indirectly affect the bond and stock market which in turn affect our returns.

But stock returns shouldn't be too largely affected by interest rate changes due to inflation, as stocks are hedged against inflation as they are claims on real assets which increase in value with inflation, so the real rate of return will remain the same even with an increase in inflation  (given our lack of capital gains tax).

Interest rates sometimes are affected by the government's monetary policy. While Singapore doesn't use interest rate to control monetary policy, other countries such as the US's Fed. An increase in interest rates can be used to rein in inflation while a decrease in interest rates can be used to stimulate the economy such as in the 2007-2009 financial crisis. Likewise, an increase in the interest rate will lead to a decrease in stock and bond prices and vice-versa, except that stocks do not benefit/suffer from the increase in profits due to inflation or decrease in profits due to deflation.

Interest rates and inflation are 2 things which we should look out for when investing as they have the potential to greatly affect our real rate of return as mentioned above. This is also why a change in the Fed interest rate generates such great interest from the market or how Japan thinks it can stimulate the economy by offering negative interest rates


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