Do interest rates need to stay high to hedge off inflation? Interest rates have a complicated relationship to inflation with various pros and cons in terms of raising interest rates to try to combat inflationary pressure.
The federal reserve does not reach the decision to raise interest rates lightly. This decision is made only when the severity and persistence of inflation and the overall state of the economy are deemed to necessitate it. This does not mean that it is a perfect system, and interest rate hikes remain something that investors should stay abreast of to protect their investments.
The financial advisors at Avidian Wealth Solutions, a Houston financial management firm with $4 billion in assets under management, are here to share several of the reasons why interest rate hikes happen, why they are an imperfect solution, and to offer some investing tips to help see you through the heights of inflation.
Should you raise interest rates to fight inflation?
Why do interest rates rise with inflation? Let us first explain why, theoretically, the Fed raises interest rates to fight inflation, and how it is supposed to work.
In the simplest terms, raising interest rates makes it more expensive to borrow money, which makes many people cut back their spending on consumer goods and services. This decrease in spending should, theoretically, lead to a decrease in the price of those goods and services when sellers are forced to lower their prices to retain customers.
Higher interest rates also attract foreign investment, which can increase the value of a nation’s currency significantly. A strong currency can make importing cheaper and exporting much more profitable, boosting the demand for domestically produced goods and further decreasing inflation.
Theoretically speaking, interest rate hikes are intended to stave off inflation, but this isn’t always the outcome.
Why raising interest rates won’t stop inflation entirely
Raising interest rates alone will not always be able to curb inflation. As previously mentioned, it is just one tool in the Fed’s “combating inflation” toolbox. Some reasons why interest rate increases do not always fight inflation include the following:
- Inflation is often caused by factors outside of the control of any economic policy. Think of supply chain disruptions, natural disasters, and geopolitical snags such as new tariffs or trade legislation.
- Interest rate hikes, if executed too quickly, can actually slow down economic growth because of the decreased economic activity.
- Root causes of inflation can also lie in structural or technological changes that will be unaffected by interest rate hikes.
- Rate hikes are not always the right choice. Sometimes a temporary decrease in interest rates can actually support economic activity and prevent further economic downturns.
Raising interest rates is just one way in which central banks attempt to lessen the effects of inflation on the market. Although interest rate hikes are usually part of a larger federal inflation action strategy, they are one of the elements that most acutely impact investors.
What are the best investments during inflation and recession?
Whether you’re wondering how to profit from rising interest rates or how to survive inflation, the first things that you might consider are what assets have historically been shown to perform well during periods of high inflation.
- Commodities can be a great asset during inflation, as their value often increases alongside prices. Commodities can also be a way to hedge against the pressure of inflation, making them possibilities for people wondering how to profit from rising interest rates and those wondering how to protect their portfolios during inflation.
- Real estate — while technically a commodity — deserves a special mention as it tends to do very well during inflation. Commercial real estate and rental property investments can have a particularly high potential for returns during inflation.
- Stocks and bonds can provide the opportunity to protect capital and provide steady returns during inflation. Stocks, while a bit more volatile, offer the potential of high returns over time, while bonds can offer the security of fixed-income payments.
Although these assets have historically performed well during inflation, there are really no best investments for inflation protection, if you really want to protect your assets and your portfolio, or are wondering how to protect your 401(k) from a stock market crash, you’re going to have to partner with experienced and trusted financial advisors who can assess your risk and help you develop an ongoing strategy against it.
What are the worst investments during inflation?
Understanding the effects of inflation on investment, and how inflation can impact different types of investments, is vital for those looking to come out of the other side of inflation stronger. The tricky thing about inflation, and volatile markets in general, is that the best investments for inflation protection can become the worst without a moment’s notice.
Generally speaking, the investments that are most negatively affected by inflation are cash investments. Savings accounts, CDs, and other kinds of cash equivalents will lose value as their value stays static and the prices around them rise.
That being said, cash investments are an important part of a diversified, balanced portfolio. Making sure that you’re positioned correctly to weather inflation or a recession is about more than buying up all of the real estate and dumping all of your cash investments. You need to make sure that your assets, investments, and risk are calculated to ensure that you can weather the hit when the market changes again because if we only know one thing, we know that market conditions will change.
Wondering how to survive inflation? Avidian Wealth Solutions can help
So, do interest rates need to stay higher to hedge off inflation? Interest rate hikes are a useful tool that the Fed can use in their efforts to stave off persistent inflation, but they don’t solve the whole problem. As an investor, all you can do is be prepared to ride it out.
Want to set you and your family up so that you are ready for whatever comes next? The best way to do that is to partner with a wealth management firm that offers comprehensive and ongoing wealth solutions.
Avidian Wealth Solutions offers fiduciary investment services, risk management, retirement planning, estate planning, and more — all under one roof. If you’re a high-net-worth individual, executive, or entrepreneur looking for financial planning in Houston or Austin, schedule a consultation with us today. We would love to tell you about Avidian’s approach to wealth management.
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