At a time when headlines have understandably been dominated by political debates and pandemic developments, tracking the biggest news from one week to the next can feel like monitoring a constant barrage of breaking news, big stories, and dramatic events that capture the imagination and drive the conversation.
One of the biggest stories in 2021 however—and potentially one of the most important and impactful storylines in 2022, as well—involves a topic that doesn’t always get the blood pumping or drive clicks and views online: inflation and interest rates. We can probably expect more attention being paid to these two interconnected issues going forward, because the costs and consequences of ongoing inflation and what is almost certain to be a corresponding rise in interest rates have a direct bearing on the literal and figurative fortunes of people and businesses across the country. A relatively modest change in interest rates can have a comparatively dramatic impact on bottom lines and bank accounts.
If, as many analysts and financial experts predict, interest rates do rise throughout 2022, then it will be particularly important to understand not just the relationship between inflation and interest rates, but why and how those indices can impact the value of your assets and your investment decision-making.
Inflation, the rate of increase in the cost of goods and services increase, typically spikes when increased production costs coincide with strong demand for products and services. That exactly describes the current circumstances in the American economy, which is why 2021 saw the highest increase in U.S. consumer prices in almost 40 years. Labor Department data released in January revealed that the consumer price index (CPS) rose 7% last year, the largest one-year increase gain since 1982. For families and individuals, higher prices means that paychecks don’t stretch as far. But it also means that the Federal Reserve (the “Fed”) is very likely to raise interest rates in response. The Fed, the central bank of the United States, is responsible for monetary policy specifically designed to keep the economy balanced. When inflation spikes, as we saw in 2021, the Fed’s response will likely be to change the federal funds target rate (the rate at which commercial banks borrow and lend their excess reserves to each other overnight).
While any interest rate increases would help rein in inflation, they have profound effects that ripple across the economy. Financial guru Warren Buffett once put it this way: “At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset.”
Rates set to rise
As a rule of thumb, when interest rates rise, stocks and bonds decrease in value. The dips and volatility we’ve seen the stock market so far this year are almost certainly the result of an anticipated series of interest rate hikes in 2022. The impact on fixed income could be even more significant, considering the fact that the bond market is several times the size of the stock market. Rising interest rates discount the price of fixed-income securities, which subsequently lose some of their investment appeal relative to higher ROI opportunities once those rates exceed the fixed rate at which the securities were purchased. And there is plenty of room for interest rates to go up, because current rates are extremely low—especially when put into historical context. The yield on 10-year treasury notes is around 1.75%. While that’s a little higher than the incredibly low 0.53% we saw in August 2020, it is still low when compared to the 3% yield we saw as recently as 2018, and 5%+ in 2002.
While making any definitive financial predictions is risky business, rising inflation and low interest rates is a combination that would seem to make interest rate hikes a near lock for 2022. We could see the first increase as early as March, and additional increases later in the year are also likely. Because the price of the assets in an investor’s portfolio are likely to decrease as a result, there is a tendency for some investors to get nervous, to make hasty sales, and to trade on the margin at times. It’s important, however, to recognize that these are structural ebbs and flows in the market: part of the normal fluctuations we see in response to inflation and Fed policy. Savvy investors—and financial advisors—recognize the value of long-term thinking and the perils of being reactive and will avoid making any impulsive moves that will only harm them in the long run. Long-term investing is full of these kinds of ups and downs, and staying the course requires both discipline and a better understanding of why the markets are reacting as they are. The cyclical connection between interest rates tweaks and inflation is a continuous and ongoing dynamic, and investors at all levels would be wise to remind themselves that the price of an asset and the long-term value of that asset do not always (or even often) align.
So, while rising interest rates could end up doing a number on short-term asset valuations, as long as your risk level is appropriate, there is no reason to sell in a panic. In fact, conditions in 2022 might actually present a potential buying opportunity. While investors should be cautious about letting macroeconomic factors dictate any personal investment decisions, and should discuss these issues with their advisor, keeping these general ideas in mind as we monitor rate changes and market movement throughout 2022 is wise.
Brian Nemes, co-founder and partner at Nemes Rush, is responsible for managing his clients’ many financial needs. A voracious researcher, Brian goes above and beyond for each of his clients every day. In addition, he serves as Chief Compliance Officer overseeing equity research and client service protocols.