Before we start looking at what you can do to navigate the challenging waters of inflation and interest rates, let’s make sure we’re all speaking the same language.
Interest refers to the cost of borrowing or the return on savings. Sounds simple, right? But this basic concept can have a dramatic impact on our economy.
Interest rates are affected by inflation and the subsequent monetary policy of the Federal Reserve. I like to use a bathwater analogy. You want the temperature right. When inflation is high, the central bank turns on the cold water to increase interest rates, making money more expensive to borrow, which reduces consumer spending and “cools” the water in the economy. On the other hand, if inflation is low, the central bank will turn on hot water by reducing interest rates to facilitate consumer borrowing and spending. As a result, the economic waters are heating up.
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When interest rates are high, investors want greater returns from their investments to compensate for the loss of purchasing power due to inflation. When inflation is low, investors may accept lower returns, meaning lower interest.
How interest rates and inflation affect markets
We also see the effects on the stock market. When interest rates are high, some investors abandon their stock portion of their investment strategies to seek fixed rates in savings vehicles such as CDs, fixed annuities or bonds. When enough investors do this, we see the stock market decline. When interest rates decline, investors start looking for ways to grow their money, and some may revisit their stock strategy.
Many of my client conversations revolve around this topic. Last year, one of my clients was considering exiting the diversified mutual fund strategy we had built to switch to a more conservative strategy. We revisit their “why.” Why are they increasing their mutual fund portfolios? Their answer is that they want to ensure that they have enough assets to add to their retirement within eight years.
Their time horizon, or how much time they have saved for their retirement goal, is an important piece of information because it helps determine their investment allocation, or how their accounts are invested. After our review, we found it suitable for their purpose and ultimately decided against the more conservative strategy.
Focus on the ‘why’ rather than the emotions
Many of my clients ask me how to navigate the uncertainty in the interest rate landscape, because we don’t know how the Fed will adjust. I ask them to look at their “why” when it comes to their ongoing contributions to retirement accounts, or how they use an investment account. We review our goals and time and ask ourselves if our plan needs a change versus our emotions telling us it needs a change. When we experience negative returns, our emotions tell us to cut our losses and get out. When the market is going well, we want to get in and not get out.
If your investment strategy is to liquidate when the market is down and return when the market is up, that is a recipe for failure. A disciplined investor revisits their “why” and the path they took to achieve their financial goals. That evaluation often reveals the opportunity to add more to their investment account when the market falls.
High interest and inflation rates are nothing new – they have happened in the past, and investors have weathered them. We are too.
Case studies may not be representative of the results of all clients and are not indicative of future performance or success.
The opinions expressed are those of the author and do not necessarily represent those of the employing company. Case studies may not be representative of the results of all clients and are not indicative of future performance or success. FM-6001461.1-1023-1125
This article was written and presents the views of our contributing advisor, not the Kiplinger editorial staff. You can check advisor records using DECLARED by SEC or with FINRA.