Unveiling the Economic Symphony: How Inflation and Interest Rates Shape Markets and Industries

When we see the two major factors interest rate and inflation, there seems to be a positive relationship between them.

Here, in this article, you will understand how inflation leads to the rise of interest rates and its impact on the macroeconomic situation of any country.

Unlocking the Relationship between Inflation and Interest Rates

Let’s start with the demand and supply of any product/commodity. Generally, what happens is the price of any commodity increases when the demand for that product increases but supply remains constant.

Let’s suppose, Nepal has only one supplier who can manufacture and supply readymade laptops to their customers and has the capacity to supply only 100 laptops. But if the demand for that laptop goes on increasing and reaches 150, the supplier may either need to increase their production capacity or need to import from foreign where in both cases would lead to an increase in the cost of the laptop which can be called inflation. So, inflation is the rise of commodities’ prices which leads to the fall of purchasing power of money of the consumers.

Generally, what happens is if the public has more money, they will demand more products from producers which results in more demand and supply gap. Now, here comes the role of the central bank of a country. It is not possible for any country of central bank to go to the manufacturers to supply more commodities.

Or let’s go to the above example, it is not possible for the central bank to go to individual customers to demand fewer laptops or to the suppliers to manufacture more laptops. So, what they do is they will increase the interest rate in the market which will close the gap between demand and supply which will reduce the purchasing power of money of the consumers and will demand fewer commodities.

As a matter of fact, we generally buy commodities through loans and can only demand huge products if the interest rate of the loan is less. But if the central bank increases the interest rate, those who have taken a loan will need to incur more interest rate than they were paying and will not demand more commodities in the market or who are willing to borrow a loan may think twice if they have stable income level in the market.

Impact of Interest Rate on the Stock Market of the Economy

When the central bank raises interest rates in their economy majority of people will not have to afford to borrow loans at such increased interest rates which will lead to a fall in margin lending and may lead to the fall of interest income of BFIs. Similarly, the interest expenses of BFIs will continue to increase as BFIs may need to increase the interest rates on their products to compensate for the inflation. With the impact of these factors, the financial performance of BFIs will be negatively impacted leading to a fall of profit distribution to their shareholders which can be reflected on the stock market.

Impact of Interest Rate on Real State Industries of Economy

People will not be capable enough to borrow loans at such an increased interest rate which will lead to a fall in demand for real estate properties. And, if the demand for real estate properties goes down, the ecosystem of the real state of an economy will be imbalanced as ultimately the demand for bricks, cement, iron rods, steel, and other related equipment will also go down. As a result, the stock of real estate properties goes down as the profit distribution capacity goes down.

Impact of Interest Rate on Auto Industries of Economy

With the rise in interest rates people will not be willing to borrow auto loans from BFIs and the impact will be reflected in the stocks of auto companies.

The Defense Sector: A Shield against Economic Volatility

Now, till now we have discussed the impact of the rise of inflation and interest rates in sectors like BFIs, real estate, and auto but there are some sectors where the fall or rise of inflation and interest rate will not impact like pharmaceuticals, FMCG, and IT industry. For easy understanding, I will call these three sectors as defensive sectors.

When inflation happens on the products of these defensive sectors people will not stop purchasing the consumption of products like soaps, shampoos, toothpaste, medicines, etc. which will not lead to the fall of demand for these defensive sectors and stock will not move down.

Fixed Income Instruments: Navigating Market Volatility

There is an inverse relationship between market interest rate and fixed income instruments i.e. market value of debenture. Suppose, one BFI issues a debenture of Rs. 1 million at a 10% coupon rate with a maturity period of 10 years and gets listed on the stock exchange where at that time there was inflation of around 7% it means that those who purchase such debenture will receive 10% interest income on every year till this debenture mature no matter what the inflation and market interest rate is.

If the inflation increases to 8% in the economy and the market interest rate also increases and suppose another BFI wants to issue a debenture then they need to issue at the coupon rate of more than 10% because in order to compensate for the rise of market interest rate, public will be attracted to buy this debenture and due to the selling pressure of previous debenture will ultimately lead to the fall of its market value.

A similar case happened in the USA with Silicon Valley Bank (SVB) when the Federal Reserve increased interest rates in order to compensate for the rise in inflation rate. When the interest rate was increased then the market value of bonds that SVB had purchased before started to fall because they paid a lower interest rate than what a comparable bond would pay if issued in today’s higher interest rate environment. So, to fund the redemption, SVB sold $21 billion of bonds at a loss of $1.8 billion.

Conclusion

Understanding the intricate relationship between inflation and interest rates is crucial for investors, businesses, and policymakers alike. By recognizing the impacts and strategies employed, individuals and institutions can navigate economic fluctuations more effectively.

Article by: Bishal, ACCA Student