A participant from my investing course asked me this question, so I felt it would be useful to share with you why the Federal Reserve (Fed) is raising interest rates to combat inflation.
Wait… what causes inflation in the first place?
Ultimately, inflation happens when there’s too much demand chasing too little goods or services (i.e. supply). A shortage happens and this signals to the providers of goods and services that they are able to charge more!
The increase in profits and margins draws more competition into the industry as a result. It will take time, but eventually enough new entrants will come in until there’s sufficient goods and services provided to meet the demand.
Demand driven inflation happens when…
- Too many jobs are chasing too few talents, causing wages to rise rapidly. Increasing the purchasing power of employees.
- There was too much money injected into the economy (e.g. COVID-19 relief measures).
- The low interest rates encourage people to spend now rather than save for the future since they are compensated little for delaying consumption.
- Additionally, low interest rates encourage businesses to borrow more in order to expand, either by hiring more workers (raising wages) or building more factories (raising raw material demand).
Supply driven inflation happens when…
- Government regulations (e.g. Malaysia banning the export of chickens to Singapore)
- External shocks to the system (e.g. Russia-Ukraine war).
- Supply chain disruption (e.g. China lockdowns).
- Price collusion (e.g. Oil cartels)
Rising interest rates suck money (demand) out of the system.
Borrowing becomes more expensive for us and for businesses as interest rates rise. Additionally, it encourages people to save more for the future as they are rewarded with higher interest rates for delaying consumption.
This results in:
- Businesses reducing investments in expansion, cutting their demand for materials and human capital (easing off wage hikes).
- Consumers reduce their spending because it is now costlier to borrow and also, they are compensated more to save.
- This effectively reduces demand for goods and services.
How effective are interest rates at fighting inflation?
Unfortunately, not so much. In his 2022 semi-annual letter, Terry Smith stated, “Interest rates as a tool to combat inflation are a blunt instrument at the best of times and I suspect more so in this instance where the inflation has not been caused by demand exceeding supply during an economic boom.”
Increasing interest rates may help quell demand-driven inflation, but it will not quell supply-driven inflation, such as that caused by the Ukraine-Russia war or supply chain problems.
What should investors do with rampant inflation?
Own companies that can outperform inflation. Louis Vuitton’s parent company, LVMH, blamed their move to raise prices on inflation. It sounds as though their profitability will be reduced due to the rising costs of producing these designer products.
But when we take a look at their gross profit margins, it is actually at an all time high! Their profitability hasn’t been reduced at all, in fact, their pricing power outpaced the rising cost.
Similarly, there are many businesses out there that are less affected by both inflation and interest rate increases. For example, Adobe has no raw materials costs for selling additional subscriptions of its software and as it has already been profitable with lots of free cash flow gushing in, they have no debt and are not affected by rising interest rates.
I hope this has been helpful for you! If you are wondering why rising interest rates bring down the stock market…
>> Click here to read Why do rising interest rates cause the stock market to crash?