What Happens to Interest Rates During Inflation?The value of a dollar is relative to the number of goods or services it can buy. This is known as the purchasing power of the dollar. Simply producing more dollars will decrease the value of each dollar. So if you hold $1 for a year during inflation, you will be able to buy fewer goods or services after a year than you would do now. In this context, inflation actually helps borrowers who repay with less valuable money than the borrowed money. However, lenders, in turn, increase the interest rates on loans to make up for the loss. The Federal Reserve also “sucks” money out of the system to curb inflation by increasing the fed rate, which institutional banks use to borrow short-term funds from the money market. So what happens to interest rates during inflation? This rate hike trickles down to retail loans, and lending rates across borrowers steadily rise. Most variable/adjustable-rate loans are directly correlated to the fed rate. For a broader understanding of inflation, we use the consumer price index (CPI) as a standard measure of price. It is a weighted average of consumer goods and services like fuel, transportation, clothing, housing, food, and entertainment. Inflation is the percentage change in CPI.
How Inflation Helps BorrowersIf you had taken a fixed-rate loan pre-inflation, you could benefit from unanticipated inflation in several ways. First, you get a natural advantage for fixed rates since the current rate keeps increasing. Moreover, since the US dollar's purchasing power (or simply value) decreased since you took the loan, you can now repay the same debt with “cheaper” money. It makes sense because you will earn more in wage or business income during inflation yet pay the same rate for your loans. Since the government borrows money from bondholders, inflation actually makes it easier even for the government to repay debts to bondholders. However, if you had taken an adjustable-rate loan pre-inflation, you may not get the desired benefit since the increase in interest rates will counter any inflationary edge. On the other hand, if you wish to take a loan when inflation is highest, you may want to consider adjustable rates rather than fixed rates. You can also pay off some of your debt or refinance your existing loans according to inflation cycles to get the “invisible” benefit.
How Inflation Helps LendersInflation is a transfer of wealth from lenders to borrowers. However, lenders operate their businesses based on rate spreads and may benefit from rising interest rates during inflation. Let’s understand how. Lenders directly or indirectly use depositors' money to fund loans. They pay interest on the deposits, known as the cost of capital. The real interest rate on savings accounts is the difference between inflation and the deposit rate offered by banks. As inflation increases, the value of money in the savings (cost of capital for lenders) decreases, but lenders still earn more from rising interest rates. Lenders also make money during inflation from higher demand for credit since consumer expenses and wages rise concurrently.
Who Is Helped by Inflation?Different market participants benefit from inflation. However, inflation seldom helps innately, and you may need to take long-term financial decisions during inflation to benefit from it. Let’s take a deeper look at who is helped by inflation:
GovernmentA long-term beneficiary of inflation is the government. Inflation drives up prices of goods and services and increases tax collection, a portion of which is used to pay off government debt to bondholders at a cheaper price.
Fixed-rate borrowersFixed-rate borrowers gain notionally by paying a fixed interest while interest rises elsewhere—borrowers of federal student loans and fixed interest mortgages benefit greatly from inflation. You can refinance your loan to a fixed rate if you feel inflation is on the rise.
Adjustable-rate borrowersThough rising interest rates can hurt variable-rate borrowers during inflation, an increased wage or higher business income may offset the rate hike in some cases. They should use inflation as an opportunity to pay back the maximum amount possible or even refinance with a fixed rate.
StockholdersWhen the government raises the fed rate to counter inflation, there is a shift from equity to debt. However, equity investors who focus on companies from specific sectors like commodities and real estate can make a profit from inflation. Companies producing consumer goods and services may not do well during rising prices due to low demand.
Commodity holdersCommodity investors are the primary beneficiaries of inflation due to rising commodity prices. Commodities like energy, food, and metals react heavily during inflation. However, sudden supply shocks from global events can create wild volatility swings in prices.
Inflation-Indexed BondsTreasury Inflation-Protected Securities (TIPS) and Indexed Bonds (I-bonds) offer lower than average yields but can rise sharply during inflation.
Is Inflation Good for Homeowners?Overall, inflation is good for homeowners as house prices and home rent increase during inflation. However, the cherry on top is the mortgage. Homeowners with fixed-interest mortgages get the most benefits from inflation. They get to enjoy the rise in their property valuation and quote a higher home rent due to inflation yet avoid the interest rate-hike pain that adjustable mortgages bear. Homeowners with adjustable mortgages may want to refinance to a fixed-rate regime with rising inflation.
Who Loses from InflationSome market participants lose wealth during inflation. They are:
Index-linked credit cardholders:
First-time home buyers
How to Fight Against InflationInflation is a remarkable redistribution of income and wealth. But how to beat inflation? You can leverage it to your advantage by understanding how it affects your savings and borrowings. You may gain from paying off your debts when the dollar's value is cheap or refinance your loans to stay on the right side of interest rate volatility. You should look to invest in inflation-hedged assets like gold, gold bonds, TIPs, commodity ETFs, etc., with your liquid cash and disposable income. You may invest in real estate as inflation increases house prices. You can also invest in emerging market economies where inflation is low through various investment apps.