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From buzzwords to action: Inflation and interest rates

Updated: Apr 9

The buzzwords for 2023 are “inflation” and “interest rates.”

They’re dominating Google searches on a monthly basis. But how are they related, and what should you, as an investor, consider?

Let’s break it down in this blog.

Understanding inflation

Inflation is a general rise in prices, resulting in reduced purchasing power. In simpler terms, your money doesn’t stretch as far.

There are two main causes of inflation: demand-pull inflation and cost-push inflation.

Demand-pull inflation

Demand-pull inflation occurs when too much money chases too few goods and services. Examples include:

Economic boom: When the economy is doing well, businesses make more profit and people have more money to spend. This can lead to increased demand for goods and services.

Government spending: When the government spends more, it puts extra money into the economy. This gives people more money to spend, which boosts the demand for goods and services.

Increase in the money supply: If the central bank prints more money, it can increase the money supply. This can also lead to increased demand for goods and services, as people have more money to spend.

Cost-push inflation

Cost-push inflation occurs when the cost of producing goods and services increases. Examples include:

Increase in the price of raw materials: If the price of raw materials, such as oil, gas, or metals, increases, it can lead to cost-push inflation.

Increase in wages: If wages increase, it can also lead to cost-push inflation.

Supply chain disruptions: Events like natural disasters, geopolitical conflicts, or a pandemic (as seen with COVID-19), can disrupt supply chains, causing shortages of key resources or components.

Scarcity leads to increased prices for these inputs, which can result in higher overall production costs.

Other types of inflation

Besides demand-pull and cost-push inflation, there are two other lesser-known types of inflation.

Built-in inflation or wage-price spiral is characterized by a self-perpetuating cycle of rising wages and prices.

Initially, demand-pull or cost-push factors cause prices to rise. In response, workers demand higher wages to maintain their purchasing power. When businesses comply, it leads to increased production costs, which are then passed on to consumers through higher prices.

This cycle continues, creating an inflationary feedback loop which is often difficult to control.

Next is hyperinflation.

This type of inflation is characterized by extremely high and rapid price increases. Hyperinflation can occur when there is a loss of confidence in the currency and people start to hoard goods and services.

Hyperinflation can be devastating for an economy, as it can lead to widespread poverty and economic collapse.

Interest rates and inflation

Interest rates influence inflation through their impact on borrowing costs and spending.

There are a few ways that interest rates can control inflation.

Higher interest rates make it costlier for businesses to borrow for investment and growth. This may slow down economic growth, but it can also curb inflation.

Higher interest rates make it pricier for consumers to borrow for purchases. This could lead to less spending, which can also help control inflation.

With higher interest rates, bonds become more appealing. Since they offer a fixed interest rate, investors can earn more on their investment when rates are high.

This may reduce the demand for other assets like stocks and real estate, which can help to reduce inflation.

Central banks, like the Federal Reserve in the U.S., use interest rates as a key tool to manage inflation. They raise rates when inflation is too high and lower them when it’s too low.

It is important to note that interest rates have a lagged effect on inflation. This means that it can take some time for changes in interest rates to have a noticeable impact on inflation.

Central banks' use interest rates to manage inflation. Understand the different types of inflation and know the role of interest rates in shaping inflation.

So, what should you do as an investor?

There are a number of things to do to protect your portfolio and potentially profit during a period of inflation.

Invest in companies with strong pricing power. These companies can pass on higher costs to consumers without losing too much market share.

For instance, LVMH is able to increase the price of its luxury goods without impacting its market share.

Invest in companies with healthy margins which are often found in technology companies. These companies have a lot of room to absorb higher costs before they have to raise prices.

There are also inflation-resistant stocks. They are usually your utilities, healthcare companies or real estate investment trusts (REITs) which tend to be more resilient to inflation.

For me, I have a healthy allocation for REITs which provides me stability as well as regular dividends. You can check my REITs screener here.

Last but not least, it is important to diversify your portfolio!


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