The Normal — and Occasionally Not So Normal — Relationship Between Inflation and Interest Rates
“A nickel ain’t worth a dime anymore.”
~Yogi Berra
Investors have faced a very challenging environment so far in 2022, with most broad asset classes losing value through the first half of the year. While stock investors should expect periodic losses as they pursue long-term growth, investors usually look to bonds as the “safer” allocation within their portfolio, and they generally expect them to buffer their portfolio somewhat when stocks decline. In a surprise to many, that hasn’t been the case so far in 2022, as stocks and bonds, even many of the highest quality, suffered double-digit losses in the first half of 2022. Stocks and bonds have rebounded somewhat as of this writing; however, both remain down for the year, pressured by something most current investors haven’t experienced: high inflation.
One measure of inflation, the consumer price index (CPI), showed prices in the U.S. increased by about 8.5% over the past 12-month period ending July 31. This means that dollar you’ve been carrying around in your wallet for the past year can only buy about 91 cents worth of what it could a year ago. The Federal Reserve, which provided unprecedented amounts of monetary stimulus during the COVID-19 pandemic, has begun to withdraw some of that stimulus to fight inflation. Starting in March 2022, it moved away from a policy rate of near zero, initiating its first rate hike since December of 2018. The initial increase was followed by more aggressive increases at each subsequent Fed meeting in May, June, and July, and the market expects this policy tightening to continue as broad inflation has shown only mild signs of abating.
Inflation has a strange effect on businesses and all sorts of other economic functions. While not the most academic definition, one pretty spot-on explanation is, “Inflation has an impact similar to putting a magnet near a compass. Everything gets a little screwy.1” To illustrate, imagine being the CEO of a large equipment maker who took a large order today at an agreed-upon price, but you will be buying raw steel and electrical components throughout the next six months, then paying labor and other costs to fabricate and assemble for a year after that, and then delivering the product 18 to 24 months after the order. One more thing, you are going to finance your customer’s purchase over the next decade. Whether inflation is 4% or 7% during the course of the project will have a huge impact on your final profit, or even ability to profit at all, from the project.
Inflation also has a certain relationship with interest rates. Namely, when inflation rises, interest rates usually rise, and vice versa. Figure 1 illustrates the historical relationship between interest rates and the yield on the 10-year U.S. Treasury. While not perfect, inflation and interest rates usually trend together over the long term. Periods of high inflation are typically also periods of high rates, and periods of low inflation are normally periods of low rates. This relationship has generally held throughout numerous different economic environments, including wars, impeachments, high inflation, low inflation, expansions, recessions, oil embargos, tech bubbles and busts, housing bubbles and busts, and more.
Figure 2 also illustrates this positively correlated relationship between inflation and interest rates. Here we plot the same data as in Figure 1, but it is displayed in a scatter plot instead of on a timeline. Each dot represents a point-in-time snapshot of the 10-year Treasury yield and the inflation rate in a certain month in history. The thin dotted line shows us the summary of the relationship over time; namely, higher inflation is typically associated with higher rates, and lower inflation is usually associated with lower rates.
There are historical outlier periods, however, where the “normal” relationship breaks down when inflation and rates diverge from each other, and the current experience in 2022 falls into that category. Figure 3 highlights four outlier periods in the relationship between interest rates and inflation:
Green (1974–1975): This period was a very difficult economic environment. Social problems like President Nixon’s resignation, a struggling war in Vietnam, and protests in the streets set a sour national mood. The economy was in recession and unemployment was rising quickly. As the economy contracted, inflation was high and rising, ushering in the term “stagflation.” The contracting economy and declining stock market soured investor appetite for risk, so the bond market remained attractive by comparison, holding yields well below the rate of inflation.
Orange (1981–1985): This period represents the time — during and after — when Fed Chairman Paul Volcker dramatically raised the federal funds rate to fight the high inflation of the late 1970s and early 1980s. While he was successful in reducing inflation, it came at the high cost of a deep and prolonged economic recession. The official inflation rate fell below 4% by the mid-80s, reaching a low of almost 1% in 1986; however, the rate on the 10-year Treasury stayed elevated, remaining above 10% until Q4 of 1985. The 10-year U.S. Treasury yield continued in secular decline for over 40 years, setting up a multi-decade bull market in bonds and contributing to strong returns in equities.
Yellow (2011–Q1 2021): This is the period after the global financial crisis of 2008–09, which was characterized by unprecedented global central bank stimulus aimed at staving off deflation, or worse, depression. While a depression was avoided, a European debt crisis followed, ushering in even more central bank stimulus. Economists began to measure the levels of stimulus in ($) trillions instead of ($) billions, and new terms like “quantitative easing” entered the vocabulary. This stimulus continued throughout the 2010s and while attempts were made to scale it back periodically, it again accelerated due to the COVID-19 pandemic, which saw trillions more in stimulus flood economies.
Blue (Q2 2021–2022 YTD): This oval captures each of the past 16 months (through July 2022) and shows relatively low interest rates with relatively high inflation. While interest rates have increased in response, they only peaked near 3.5% in June and have been hovering below 3% for most of the third quarter. Contrast that with inflation which rose from about 5% to over 8% in the last year.
As is evident from the descriptions above, the historical relationship between inflation and interest rates moving away from its “normal” state has occurred in varied economic and market environments; however, these periods seem to share one commonality: They all occurred in periods of transition. In the mid-1970s, the post-World War II boom was ending, and the U.S. dollar had moved off the gold standard. The early 80s was the other side of the 1970s, where inflation was in decline, the U.S. was emerging from recession, and economic growth was accelerating. The 2010s was a period of massive monetary intervention following the global financial crisis and Europe was grappling with frailties of a common currency combined with uncommon fiscal policies across member countries. Finally, today we are transitioning to a post-pandemic world where supply chains have become constrained and the massive fiscal and monetary support of the past has created imbalances in many parts of the global economy. One result of the current imbalances is the elevated inflation experienced over the past year.
While interest rates have begun to rise in reaction to the recent spike in inflation (at about 2.9% as of August 15, 2022), the 10-year U.S. Treasury yield remains well below the official inflation rate of 8.5%. In a purely academic world, the trendline in Figure 3 suggests interest rates should be closer to 9%. To be clear, a 9% rate on the U.S. Treasury bellwether in the current economic environment is unrealistic and not in our forecast. However, based on the historical relationship, we expect over time the two rates should move closer together. This can happen with U.S. Treasury yields moving higher, through a moderation in inflation, or both. To be sure, the focus of current Fed policy is to achieve the latter by constraining lending and slowing the economy. Recent inflation reports have shown a slight easing. However, inflation remains well above the Fed’s long-term target of closer to 2%, and Fed messaging continues to indicate a hawkish stance targeting more rate hikes in the future. At Transamerica, we believe inflation should continue to moderate as the year progresses, but many dynamics outside of the Fed’s control create heightened uncertainties. As Transamerica Asset Management CIO, Tom Wald, CFA®, noted in the Transamerica 2022 Mid-Year Market Outlook .
“We see the core rate of inflation mitigating into the sub-4% range by year-end as Federal Reserve tightening and a consumer shift from goods to services begin to provide some relief to the pace of rising prices. Given recent stock and bond price declines, we still view this economic environment as opportunistic for longer-term investors, although the war in Ukraine, oil prices, and ongoing COVID-19 trends are potential wild cards.2”
Should inflation moderate as expected due to the slowing economy and more restrictive Fed policy, traditional investment strategies employed by most investors that allocate primarily to various equity and fixed income sectors could rebound as the cycle turns. If, however, inflation remains elevated for an extended time frame it could create a more challenging environment for both equities and bonds. In historical economic regimes defined by high inflation, alternative strategies such as real estate and commodities have tended to add value. In fixed income, some nontraditional assets like floating rate securities and flexible active strategies have been good diversifiers, as have certain equity investments in energy and other commodity producers. While we don’t advocate aggressive changes in portfolios that move away from long-term goals, some changes around the edges may improve results if inflation persists for longer than expected.
1“CWS Market Review,” by Elfenbein, Eddy, December 14, 2021, crossingwallstreet.com/archives/2021/12/cws-market-review-december-14-2021.html
2“Transamerica 2022 Mid-Year Market Outlook,” by Thomas Wald, July 2022, transamerica.com/investments/market-insights-commentary
Article by Kane Cotton, CFA®
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