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Interest rates, inflation and risk

Inverse relationship: interest rates and inflation (Image by wethink-finance.com)

Global interest rates to combat inflation have now reached a level not seen since the height of 2007, meaning that savings rates and money market mutual funds dividends are increasing, also.

No doubt that many of us who have been so frustrated coping with the rapid escalation in food costs that we’ve probably had little time, energy and/or surplus budget cash to consider the benefit of those higher interest rates.

Why do interest rates in an economy fluctuate?

There is generally more than one causative factor that may be impactful, although an extreme disruptive event can trigger a reactionary response of larger significance.

Economic market disrupters are many, some temporary, others more permanent: trade tariffs, embargoes, natural catastrophes, food supply-chain disruptions from droughts, Ukraine invasion (and wars others, historically), recessions, supply and demand imbalances, country credit rating downgrades, unemployment, severe unanticipated capital market crashes, massive power grid interruptions, artificial stimulus or controls, pandemics (who could imagine in a hundred years?) and digital or fiat cash liquidity or lack thereof.

The economic community has studied and researched economies, capital markets and central bank roles for hundreds of years – in the process generating numerous explanatory positions on monetary policy that are difficult for the layperson to follow.

A couple of simple economic statements may be relatively familiar, keeping in mind that the whole economic picture is far more complicated and interrelated.

One, central banks increase the money supply, which fights recessions and increases economic growth, or contraction of the supply pulls money out of the economy in order to fight inflation.

Two, low interest rates (cheap money) increases investment in industry development, technology, employment, etc, but puts a real damper on household savings.

Conversely, central banks, such as the Federal Reserve, push interest rates higher. While very beneficial to household savings, it also seriously erodes careful budgeting, limiting spending on purchasing vehicles, real estate etc. Industry responds in kind as well, enacting cost-savings initiatives, making redundancies, putting infrastructure capital investing on hold and the like – because the cost of borrowing has increased.

The idea behind the high interest rates falls right into avid consumer shopping hands. When goods and services are priced too high, sellers will lower prices to attract and retain customers. Enough proactivity in this policy exercise and prices will stabilise and inflation will slow to a more manageable level.

The regular family version of economic theory

In a way, it is ironic: better interest investment/savings rates equals higher personal cost-of-living expenses.

Families and communities at the end of the economic cycle’s spectrum know only what is real and now. Inflation may be impacting the management of their money and the ability to counter-attack loss of buying power.

Except that the management of your money is still within your control.

You can elect to buy less, eat less, pare down your closet, use less air-conditioning, entertainment, and many other cost-efficiencies – look for them on the internet – they are there under the label of frugality, managing money and so on.

Try to stay on your self-sufficiency target

Set a small goal to save something, no matter how small, every month. Then as soon as you can, put that money to work.

Two conservative investment choices are:

• Savings or fixed deposit-type bank accounts, or

• Money market mutual funds

Keep your liquidity for emergency requirements in mind also.

If you want the savings to be contingently available for redemption, an ordinary savings account, with a lower interest rate, is a better choice than a locked-up, fixed deposit account bearing a higher interest rate.

Money market mutual funds when interest rates are rising, on average generate higher rates than fixed deposits because they are traded frequently within very short-term debt parameters.

They do carry risk. A money market mutual fund of US treasuries is less risky than one carrying commercial paper and other unsecured debt and the like. Further, there are different net asset value structures: one features a fixed net asset value (NAV) while others allow the NAV to float.

Most local investment firms carry one or more money market mutual funds. If you are interested, be sure to get your broker to explain these differences to you.

Also take the time to read parts one and two in-depth articles on money market mutual funds that I wrote last year, as interest rates started to climb.

Thank you, readers.

Martha Harris Myron is a native Bermudian with US connections and the finance journalist to The Royal Gazette for 22 years, creator of The Bermuda Island Financial Literacy Network Channel (YouTube). Contact her at info@marthamyron.com

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Published March 11, 2023 at 8:00 am (Updated March 13, 2023 at 8:24 am)

Interest rates, inflation and risk

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