How does Interest rate changes and inflation impact on investments

Question 1

How does inflation impact on cash deposits?

Answer 1

Since inflation can reduce the spending power of money, in times of high inflation depositors will demand higher interest rates to compensate. Where interest rates are lower than the rate of inflation, cash effectively loses value. Consider a £10,000 cash holding, with a net interest rate of 1% and an inflation rate of 2%. In very simple terms, this would mean that the spending
power of the money at the end of the year was lower than at the start of the year because the value of the cash has only increased to £10,100 but something that would have cost £10,000 at the start of the year now costs £10,200.

Question 2

How does inflation impact on fixed interest?

Answer 2

Fixed interest is, by definition, a fixed return. In times of high inflation, this return represents poorer value and so the price investors are prepared to pay for the bond will fall. In times of low inflation, the attractiveness of the bond looks better and the price rises as demand increases. This is also true of EXPECTATIONS of future inflation. If investors think that inflation will be higher in the future, they will demand a higher running yield from it which, with a fixed coupon, can only be achieved by paying less for the bond on the market. For this reason, expectations of increasing inflation will have a negative impact on the price of bonds

Question 3

How does inflation impact on Equities

Answer 3

Good companies will usually make more money to compensate for inflation. As their costs rise, so they are also charging more for their goods and profits are maintained. This means that equities are generally a good hedge (protection) against inflation.

Question 4

How do interest rates impact on
Cash investments

Answer 4

As market rates increase, so deposit rates will generally increase, and vice versa. In times of low interest rates this will have a significant impact on those who rely on interest from their cash savings – pensioners for instance. In recent years, with historically low interest rates this has been a major reason why the government has sought to provide some respite for such savers through initiatives like the £5,000 tax-free starting rate for interest (savings income) and the £1,000 Personal Savings Allowance (PSA) for basic rate taxpayers, £500 for higher rate taxpayers. There is no PSA for additional rate taxpayers.

Question 5

How do interest rates impact on
Fixed interest investments

Answer 5

There is an inverse relationship between interest rates and the price of fixed interest securities. As interest rates rise, the price of bonds falls and vice versa. This is because as interest rates rise, the value of a fixed coupon falls and so demand falls, reducing price (supply and demand again!)

Question 6

How do interest rates impact on
Equity investments

Answer 6

Low interest rates allow companies to borrow cheaply, which will have a positive impact on profits. Likewise, in times of low interest rates, people can afford to buy more, again good for profits. As interest rates rise, it’s more expensive for companies to borrow and people can afford less – both will impact on profits.