What Is The Relationship Between Interest Rates, Growth, And Inflation? | Seeking Alpha
What is that telling us, if anything, about growth and inflation? there is a strong relationship between bond yields and the real economy, the. Misnomer About The Relationship Between The Bond Market And Inflation The common mainstream narrative is that bond yields increase. To explain the relationship between bond prices and bond yields, let's use an example. First, let's disregard today's artificially-induced interest.
However, other factors have an impact on all bonds. A rise in either interest rates or the inflation rate will tend to cause bond prices to drop.
Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices.
If inflation means higher prices, why do bond prices drop? The answer has to do with the relative value of the interest that a specific bond pays. Rising prices over time reduce the purchasing power of each interest payment a bond makes.
Bonds, Interest Rates and the Impact of Inflation
Why watch the Fed? Inflation also affects interest rates. The Fed takes an active role in trying to prevent inflation from spiraling out of control.How Interest Rates Are Set: The Fed's New Tools Explained
When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates. To try to slow the economy by making it more expensive to borrow money.
For example, when interest rates on mortgages go up, fewer people can afford to buy homes. That tends to dampen the housing market, which in turn can affect the economy.
When the Fed raises its target interest rate, other interest rates and bond yields typically rise as well. New bonds paying higher interest rates mean existing bonds with lower rates are less valuable.
Prices of existing bonds fall. An overheated economy can lead to inflation, and investors begin to worry that the Fed may have to raise interest rates, which would hurt bond prices even though yields are higher.
What Is The Relationship Between Interest Rates, Growth, And Inflation?
When rates are dropping, bonds issued today will typically pay a lower interest rate than similar bonds issued when rates were higher. Those older bonds with higher yields become more valuable to investors, who are willing to pay a higher price to get that greater income stream. As a result, prices for existing bonds with higher interest rates tend to rise. Three years later, she wants to sell the bond.
That may or may not be good for bonds.
One party lends money to another in exchange for interest and a return of the investment principal after a specified period of time. Bonds have a fixed interest payment on the face value of the bond, when the bond pays, it will pay the stated interest rate on the bond contract until maturity. When the economy slows down, the FED has several tools at its disposal to stimulate the economy.
But this causes inflation.
Bonds, Interest Rates and the Impact of Inflation - Business in Greater Gainesville
For example, if a bond pays 4 percent annually, but inflation runs at 5 percent, then the investor is losing 1 percent in terms of the value of the dollars he is being paid even though he is actually earning money and paying taxes on the interest. This encourages borrowing by consumers because it is cheaper to borrow money thus increasing economic activity and stimulating the economy. As we saw lowering interest rates is good for bonds. Unfortunately, nothing the FED does is in a vacuum and every action has its consequences.
If the FED increases the money supply too much and the inflation rate gets out of hand just like a run away nuclear reactor the FED has to slow the reaction down. To do this it has to raise interest rates which as we saw is also bad for bonds.