Inflation and Interest Rates: Everything You Need to Know

Talks of inflation often go hand-in-hand with rising interest rates. Here’s how they’re related.

Inflation is a concept most people are familiar^[1] with but few fully understand.^[2] To the average person, inflation means “things are more expensive.” That’s true: when inflation is on the rise, the cost of goods and services typically increase. But there’s also more to it.

When inflation pops up in news coverage or casual conversations, the focus tends to be on the ramifications of rising costs. How much more does a gallon of milk cost today than last year? What are people doing to cut costs? How is inflation impacting political policies?

Few take the time to explain what inflation means in economic terms, what causes it, and what can be done about it.^[3] Rarely discussed: who is hurt the most by inflation and who is most likely to benefit from it.

Similarly, while talks of inflation often go hand-in-hand with rising interest rates, the relationship between the two is barely explained. At best, there might be an acknowledgement that the Federal Reserve, the central bank of the United States, raises interest rates to counter inflation, without an explanation of how or why.^[4]

The lack of context around inflation is not terribly surprising. Most Americans feel their financial literacy is lacking.^[5] Inflation is also an objectively complicated concept for anyone to wrap their head around—and that includes some of the top economic minds in the world.^[6]

Inflation and interest rates both have profound impacts on the economy. Understanding them is critical for investors, especially for investors in commercial real estate (CRE). If you would like to understand inflation a little better, you’re in good company—and you’ve come to the right place. In this blog post, we’ll dig into the nitty gritty of inflation and what it means for commercial real estate investing.

The topics we will discuss include:

• What is inflation?
• What drives inflation?
• How is inflation measured?
• The relationship between inflation and interest rates
• Winners and losers in an inflationary environment

We have a lot of ground to cover, so let’s begin.

What is Inflation?

Inflation is defined as an increase in prices for goods and services in an economy.^[7] Technically, it measures declining purchasing power—how far a dollar goes—over time.

As a country’s gross domestic product (GDP)—the total sum of its economic activity^[8] — increases, prices inevitably rise, too. A rising GDP generally indicates that an economy is growing, which can lead to higher demand for goods and services. This can in turn lead to higher prices, and therefore inflation.

If inflation is too high, it can erode the purchasing power of people's savings, and make it difficult for businesses to plan and make investment decisions. This can lead to economic instability and slow down growth. On the other hand, if inflation is too low, it can lead to deflation, which can also be harmful to the economy. Deflation can make it difficult for businesses to turn a profit, and it can cause consumers to delay making purchases in the hope of getting a better deal in the future. This can lead to a downward spiral in which lower demand leads to lower prices, which in turn leads to lower demand, and so on.

A little inflation is actually a good thing. In fact, the Federal Reserve, also known as the Fed, tries to encourage a certain amount of inflation each year. Usually, its target is around 2% annually, and for years it struggled to get it that high.^[9] Now it has the opposite problem^[10], but we’ll get to that momentarily.

What Drives Inflation?

Inflation is driven by a number of factors but at its core, inflation is the result of a broad imbalance in economic supply and demand, or “too much money chasing too few things.”

This is where inflation differs from run-of-the-mill price changes. An individual good or service may experience price fluctuations for a number of specific, generally well-understood reasons. For example, a dry winter in Florida leads to fewer oranges being grown. There is less supply to meet the same demand, so orange prices go up. Microeconomics 101.

Inflation, however, is a macroeconomic issue. It involves aggregate demand from millions of consumers and aggregate supply across all different sectors of the economy.

Some see inflation as purely the result of bad monetary policy. It’s why inflation is so closely associated with the Fed’s policies—they help determine the supply of money in the economy.^[11] This is also where interest rates come in. More on that later.

First, let's break down the drivers of inflation a bit more. Broadly speaking, there are three drivers: demand-pull inflation, cost-push inflation and built-in inflation.^[12] All three play a role in the current bout of inflation impacting the U.S.

Demand-pull inflation occurs when people are spending more money and there is more demand for goods and services, this can put upward pressure on prices. For example, if the economy is growing and people are feeling confident about their job prospects and income, they may be more willing to spend money on non-essential items. This can lead to businesses raising their prices in order to keep up with the increased demand.

Cost-push inflation is when the underlying costs to business increase, and these increases are then passed along to customers. This may occur when raw materials or component parts become scarce, or labor becomes hard to come by. The U.S. has been racked by supply chain bottlenecks^[13] and labor shortages^[14] during the past two years, also as a result of COVID-19. When the cost of production goes up, businesses will typically try to pass these costs on to consumers in the form of higher prices.

The final component of inflation is built-in inflation.^[15] This occurs when, in response to broader inflation, workers push for higher wages to keep up with their rising costs of living. In other words, this happens when inflation begets more inflation.

How is Inflation Measured?

As noted before, inflation is not simply the cost of one thing rising quickly. Inflation is a more general rise in the cost of a lot of things at the same time. But how does one measure this? And who does the measuring?

Many government indexes^[16] track prices across the economy. In the U.S., the most-referenced index is the Consumer Price Index, or CPI, which is maintained by the Bureau of Labor Statistics.^[17] The CPI uses a hypothetical “basket of goods” to proxy the economy as a whole. This basket includes the goods and services that frequently pop up in monthly household spending, such as food, shelter, energy, autos, medical care, personal care, home furnishings and more.

When the Fed looks at inflation, it strips away volatile factors like food and energy and focuses on what it calls core inflation.^[18] The Fed does this because food and energy are prone to wild swings, and to some degree at least, those prices may be impacted by international supply and demand dynamics, which are outside the Fed’s sphere of influence.

The Relationship Between Inflation and Interest Rates

One of the Fed’s main goals is to maintain price stability, which is an important part of a healthy economy. By keeping prices stable, the Fed can help to promote economic growth and prevent excessive inflation or deflation. One of the Fed’s main tools for keeping prices stable is adjusting interest rates.

To understand how the Fed does this, let’s start with the basics: what are interest rates? Interest rates are what lenders charge borrowers for the privilege of borrowing money. This could be in the form of a mortgage, auto loan, credit card, or another method of borrowing.

So how does the Fed impact interest rates? Simply put, by adjusting its own. The Fed is the bank for banks. Banks borrow money from the Fed to lend out to others. As the Fed raises its interest rates, banks do the same. Various other non-bank lenders then follow suit.

The lower the Fed’s interest rate, the cheaper financing becomes for all. The higher the Fed’s interest rate, the more expensive financing becomes.
What does this have to do with inflation? The idea behind raising interest rates is to make borrowing less attractive to individuals and businesses. This is intended to limit demand until it matches supply, at which point prices will stop climbing.

Unfortunately, the Fed cannot simply switch inflation on or off, or dial it up or down. It can only raise rates and keep them elevated until prices stop rising. The process is an inexact science that can cause a lot of economic damage along the way to stability.^[19] But as with inflation, the losses are not universal and, in fact, some have quite a bit to gain.

Winners and Losers in an Inflationary Environment

Inflation hits hardest against the groups that can afford it the least. Specifically, those on fixed incomes and those earning low wages. Individuals with small financial buffers tend to see their buffers erased during periods of high inflation.

High inflation also impacts stocks in a number of ways.^[20] While investments in stocks tend to hold their value relative to inflation over the long term, high inflation usually has a negative impact on them in the short term. Two main factors are at play: economic activity slows, as consumers have less discretionary money to spend, and demand for stocks decreases as individuals have fewer funds to allocate to investments.

Borrowers with floating rate debts who had been enjoying low interest payments in the time of record low interest rates are now seeing those costs increase substantially. Lenders who hold floating rate bonds, however, see their investments perform relatively well at a time of widespread volatility.

Private investments, those not traded on an exchange, are able to avoid this type of volatility in times of inflation. Investments in hard assets, such as real estate^[21], tend to hold their value better and even increase in line with inflation.

Additional winners are those who were able to lock in pre-inflation prices. Housing is an obvious example. Someone with a fixed-rate mortgage will see their monthly payments stay flat during inflation, while someone renting year-to-year will likely see their costs of shelter increase dramatically. Similar benefits are enjoyed by those servicing student and business loans. Any cost that stays flat while all others rise is effectively lower.

Conclusion

Rapid inflation can be scary, especially for households that are already stretched thin financially. It can also be stressful for stock investors as they watch their portfolios trend downward, week after week, month after month, with no end in sight.

If inflation were a medical condition, some might say the treatment, higher interest rates, is worse than the disease. This is certainly true for workers facing the prospect of layoffs and those looking to finance homes or businesses.

Yet, despite the media doomsaying in the media or how it might feel in the grocery store checkout line, high inflation is not the end of the world. In fact, with the right resources and expertise, inflation can actually be used to your advantage.

Want more? Read on to learn about inflation’s impact on the stock market and how it affects commercial real estate.

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