What high inflation means for interest rates

by InvestEngine

If 2022 has been defined by one economic trend, it’s high inflation. Since the Russian invasion of Ukraine began in February, inflation across all major economies has been notably high, with the UK seeing its highest figures in decades. 

The causes are numerous but rising energy prices has been a primary driver, along with lingering supply chain issues and increased demand. For savers, these levels of inflation can be concerning, with the value of cash eroded more quickly during periods of high price rises. 

Inflation does, however, have direct implications for interest rates, as central banks move to get prices back under control and avoid a spiral. In this article, we’ll lay out why interest rates rise to combat inflation and what this might mean for investors. 

Find out how a globally diversified investment portfolio could protect and grow your wealth for the long-term, helping to smooth out the kind of market volatility we’ve seen in recent years. 

How inflation affects interest rates

In theory, higher interest rates mean lower inflation and vice versa. Until recently, we’ve been experiencing a prolonged period of extremely low interest rates. With inflation rising, central banks are forced to raise interest base rates in an effort to bring inflation back under control. 

In the UK, inflation has been way above the Bank of England’s 2% target, hitting 10.1% in September. This is expected to peak at around 11% for October (the figures haven’t been published yet). As a result, the Bank of England has raised its base rate eight times since December 2021, from 0.1% up to 3%, where it currently sits. 

In theory, lower interest rates encourage spending because there is little incentive to save. When these rates increase, the cost of borrowing increases and both businesses and consumers are put off of spending or borrowing. In periods of high interest, there is more incentive to stockpile cash. As demands for goods and services fall, price increases should slow. 

Interest rates are predicted to rise further before it is brought down, with inflation still high and central banks needing to take fairly drastic action in response. Investors, too, need to plan for these periods and ensure that their portfolios are robust in the face of high inflation and the subsequent high rates of interest. 

What investors can do 

It can be difficult for investors to navigate periods of volatility like the one we’ve been experiencing for most of 2022. Also, in times of high inflation, it’s natural to want to see alternatives to cash savings, which are being eroded at an alarming rate. Ultimately, whenever interest rates fall short of inflation (they often do) your money is losing value over time. 

So, a lot of people turn to financial markets as a way to protect and grow their wealth over time. In these environments, there are three key things for investors to remember: 

Take a long-term approach. When you put together your financial plan, you are ideally looking decades into the future. Those with longer time horizons can afford to take on more risk, increasing their potential for growth and reducing the likelihood that they’ll be too affected by any significant swings in the markets. 

Over a long enough timescale, difficult periods theoretically become small slumps in an otherwise fairly steady story of growth. We always encourage investors to see themselves as savers, not traders. We believe that an ETF-based portfolio is the best way to grow your wealth over the long-term, but it doesn’t necessarily lend itself to short-term speculation. 

Build a well-diversified portfolio. During difficult periods in the markets, some areas always suffer more than others. For example, energy has performed well in 2022, where tech and consumer retail have generally struggled. Similarly, different geographies tend to differ greatly in how affected they are by extraneous factors – the US is, for example, widely seen to be better placed to weather the current storm than Europe. 

A diversified portfolio – like one that’s built using best-in-class ETFs – may not fully shield you from negative performance, but the idea is that any damage is mitigated. For every asset with negative performance, you’ll ideally have one or more with positive performance to balance it out. Equally, you are theoretically well-placed to capitalise on the recovery as it happens in different geographies and in different industries. Long-term investing and diversified portfolios go hand in hand. 

You can leave it to a team of experts. Not everyone has the time or inclination to manage their investment portfolios themselves. At InvestEngine, we offer both DIY and managed accounts – so if you want a ready-made, actively managed portfolio of ETFs, you can get the help of our team of experts for as little as 0.25% a year. That’s just £2.50 on every £1000 you invest. 

Find out what a managed ETF portfolio could do for your long-term financial prospects by following the button below.

When investing, your capital is at risk.

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