In the world of personal finance, a frustrating reality is that uncertainty is always a factor. But it’s not the only factor. Certain things are somewhat more predictable. Among them is the connection between interest rates and virtually every other aspect of the economy. Below is a look at some of the more important of those relationships:
Interest rates and inflation: Inflation has been the financial topic of the year. The Federal Reserve has hiked interest rates twice so far in 2022, including a larger-than-average increase this week. And it’s communicated plans for further increases. What’s the Fed trying to accomplish?
An easy way to think about interest rates is that they’re the price of money. Suppose you want to buy a home. To be sure, there are always some people who can pay cash and don’t need a mortgage. But most do. And for those people, the interest rate is a key factor. Consider a $500,000 mortgage. At a rate of 2.75%, which was attainable last year, the monthly payment on a standard 30-year mortgage would have been $2,041. But today, with rates closer to 4.25%, the same mortgage would cost $2,460 per month.
The impact, as you might guess, is that many home buyers will reduce the amount they’re willing to spend so they can stay within their monthly budget. In fact, to get to that same $2,041 monthly payment with a 4.25% rate, the purchase price would have to drop about 15%. As a result, over time, people will bid less for homes. Then prices, on average, should come down. At the very least, prices should slow their rapid increase.
Mortgages are easiest to understand, but this dynamic applies to anything that needs to be financed. For consumers, this includes cars. And for businesses, this includes equipment purchases. Anyone looking to buy anything on credit will either want to pay less, or may forgo the purchase altogether. That, in turn, will cause sellers to be more accommodating, lowering prices as needed to close sales. That is the Fed’s goal in raising rates.
Interest rates and housing prices: Does that mean home prices will be cheaper tomorrow than they were yesterday? Not necessarily. On the one hand, higher rates will definitely apply downward pressure on prices. But there’s a countervailing force that comes into play. When rates are higher, existing homeowners become less interested in selling. That’s because most mortgages carry fixed rates. So a homeowner with a 3% mortgage may now be reluctant to sell because a new mortgage will carry a higher rate.
The result: At the margin, some number of potential sellers won’t put their homes on the market. Fewer homes will thus be available. All things being equal, that would put upward pressure on prices.
How does this net out? Right now, that’s the question on everyone’s mind, but it’s important to note these two opposing dynamics.
Interest rates and stocks: Interest rates also affect the stock market. This explains a large part of this year’s decline. Here’s why: According to finance theory, the value of any company should represent the sum of all of its future profits. Importantly, though, future profits need to be adjusted for inflation. That’s because a dollar next year is worth less than a dollar today. A dollar received in two years is worth even less. And so forth. The longer a company takes to produce a dollar of profit, the less that dollar will be worth to an investor today.
That effect is compounded when interest rates rise. Here’s a mathematical example: When interest rates are 3%, then the present value of a dollar of profit earned next year would be 97 cents ($1/1.03). But if rates rise to 5%, then that same dollar would be worth just 95 cents ($1/1.05).
Now consider how this would affect two hypothetical companies. The first is a food manufacturer that is very profitable but doesn’t grow too quickly from year to year. The second is a software company that is growing quickly but hasn’t yet generated a profit. When interest rates increase, the first company will fare much better than the second. That’s because a smaller portion of its profits lie in the future, where they will need to be discounted. The second company, on the other hand, which isn’t currently producing any profit, will be severely impacted, because all of its profits lie in the future and are thus subject to greater discounting. That’s why many technology stocks are down more than 50% this year, but a stable company like Procter & Gamble is down less than 5%.
Interest rates, inflation and commodity prices: This year, stocks have dropped. But gold has risen, from about $1,805 at the beginning of the year to $1,911 today. Why? This is explained by the notion that gold is a permanent store of value and thus immune to inflation. One rule of thumb, in fact, posits that an ounce of gold has always been worth the equivalent of a (fancy) men’s suit. Gold enthusiasts have shown this to be roughly accurate even going back into ancient times.
Paper currencies, on the other hand, lose value over time. We all know that, and many have felt it acutely over the past year. If we accept the idea that gold is a permanent store of value, always exchangeable into the same amount of goods, while the purchasing power of a dollar has dropped this year, then it makes sense that the price of gold has risen, in dollar terms. If the Fed is successful in bringing down inflation, we should see gold prices moderate or even drop.
How do interest rates and inflation affect other commodities, such as crude oil or wheat? This has been an unusual year. Russia’s war in Ukraine has exacerbated existing supply chain issues, and that has driven up the prices of both of these commodities. But in an ordinary year, is there a connection between inflation and energy prices or food crops? There is. Just like gold, commodities tend to be permanent stores of value. It takes the same amount of wheat, for example, to make a loaf of bread as it did a hundred years ago. But dollars are worth less. The result: It takes more dollars to buy the same amount of wheat.
This is why many people view commodities as a good hedge against inflation. The trouble, though, is that commodity prices are subject to lots of other economic forces. Crude oil today, for example, is still 20% or so below a peak it hit way back in 2008. Other commodity prices have seen similar swings. That’s why, appealing as it is in theory, I don’t see commodities as a reliable way to hedge against inflation.
It’s important to note that many of these relationships are interrelated. And because world events are difficult to predict, it’s still a challenge to know which way things will turn out. For example, will China back off its damaging “zero-covid” policy? Or will Russia back off its damaging war in Ukraine? If either or both were to occur, that would materially impact the economy over the coming year. And yet those are just two factors. For that reason, as an investor, you should always start with the assumption that anything can happen at any time—and prepare accordingly. That said, I do think it’s useful to understand these relationships because the world is unpredictable—but not totally unpredictable.