Inflation Unveiled: The Power of Interest Rates

Why are central bank interest rates increasing?

On May 11th, we saw the Bank of England increase its key interest rate to 4.5%, its highest rate in almost 15 years, just as the U.S. Federal Reserve and the European Central Bank also increased their interest rates the week before to 5.25% and 3.75% respectively.

Inflation is usually the nominated culprit behind these hikes as the year-on-year Consumer Price Index (CPI) increase remains high at 10.1% in the UK, 4.9% in the US and 7% in the EU. Central Banks usually target a 2% CPI increase per year as a sign of healthy growth.

Central Banks have a limited number of tools to target inflation and the key principle behind increasing interest rates is to limit demand by tightening the money supply. When central bank rates rise, the cost of borrowing for retail and investment banks increases and is passed on to businesses and consumers, which has a knock-on effect on the entire economy.

To put it simply, you may not want to take out a loan for a new house if rates go up from 1% to 6%. As a result, demand in the housing market may be affected, which in turn forces property sellers to decrease prices to attract potential buyers. Same idea applies for your car loan, credit card interest payment, etc.

However, this means increasing interest rates should in theory, also slow down the economy as businesses and consumers spend less. Therefore, central banks need to find a balance between tackling interest rates and limiting economic growth. These increases also have a time lag to have the full impact on inflation, as shown with the most recent CPI figures. They can also increase the pressure on some banks, as seen in the US with the collapse of several regional banks, with its liquid assets losing value quickly, causing these banks to lose access to the required liquidity to cope with the bank withdrawals.

The key question faced is: Are interest rates hikes enough to tackle inflation? Evidently, no. The war in Ukraine caused a surge in energy and food prices, the Covid-19 pandemic caused shipping costs to soar, and many more underlying issues have and can cause prices to increase (or decrease), regardless of interest rate levels.

This raises another question: What exactly is inflation?

The European Central Bank defines inflation as, “A broad increase in the prices of goods and services, not just for individual items; it means you can buy less for €1 today than you could yesterday. In other words, inflation reduces the value of currency over time.”

To measure inflation, we use the Consumer Price Index (CPI), which measures the monthly change in prices paid by consumers. In the US, the Bureau of Labor Statistics (BLS) makes a weighted average of around 80,000 prices for a basket of goods and services collected monthly from retail and services establishments, as well as rental housing units.

A healthy annual inflation is usually set around 2% by most OECD countries. As the Bank of England states on its website, “If inflation is too high or it moves around a lot, it’s hard for businesses to set the right prices and for people to plan their spending. But if inflation is too low, or negative, then some people may be put off spending because they expect prices to fall. Although lower prices sound like a good thing, if everybody reduced their spending then companies could fail and people might lose their jobs.”

When people lose their job, they also lose in purchasing power, which means they spend less on goods and services, resulting in even more businesses to fail and more people to lose their jobs, and we have entered a vicious cycle reminiscent of the 2008 crisis.

On the other hand, if prices increase too fast, people may spend less on goods and services that are not essential as purchasing power decreases, leading once again to a vicious cycle where businesses may fail: unemployment rises, overall consumer demand decreases, and the economy goes into recession.

This is why recently we have seen central banks use interest rates hikes to manage the overall supply and demand in the economy and try to bring inflation back to around 2%.

How do interest rates affect exchange rates?

As seen previously, inflation inherently causes a currency to lose value over time. On a foreign exchange level, interest rates directly impact the demand for a given currency as interest rates have a direct impact on the return of certain investments (lending, government, or corporates bonds) and savings.

For example, being Swiss, I have a savings account in Switzerland whereby the interest rate has been negative for a long time. When you have a savings account with a bank, you essentially lend that money to the bank and, the bank pays you an interest for lending them your savings. However, the Swiss Franc being a safe haven currency (meaning the Swiss Franc remains relatively stable during economic or financial crisis), creates high demand for the currency, allowing the Swiss National Bank to charge for deposits rather than pay interests to depositors, and therefore to set negative interest rates until recently.

Now that I reside in London, this means the yield on my savings account would be much higher in the UK than it would be in Switzerland and should in theory make the British Pound a more attractive currency for my savings.

However, other factors should be considered like the currency performance, the economic and financial situation of a given monetary zone/country, which may impact the overall demand for a specific demand. Japan and Switzerland for example, have the 2nd and 3rd largest foreign currency reserves in the world, which allows their currency to be very stable (amongst other things like debt to GDP ratio and trade balance) and therefore are highly attractive in times of uncertainty or war (if an embargo or sanctions are in place for example).

Conceptually, economies with better economic outlook should have better performing currencies, as they provide a safer investment vehicle. This favours dovish monetary policy and therefore lower interest rates.

On the other hand, countries with a more negative economic outlook should see their currency lose value, favouring a more hawkish and tighter monetary policy, meaning higher interest rates.

One key exception this year is the British pound. Indeed, the economic outlook for the UK remains bleak. However, the pound is the best performing G10 currency in 2023, largely part due to its crash with the mini budget plan set by Liz Truss and Kwasi Kwarteng last year, leaving it essentially no other way to go but up. Prime Minister Rishi Sunak also managed to get a deal in place for Northern Ireland where all his predecessors failed, and the latest figures suggest the UK is set to beat the most pessimistic forecasts, although the Kingdom could still face a recession with inflation remaining the highest in the developed world.

What does that mean for your business?

Interest rates and inflation are two important metrics to set up your prices and may affect how your own suppliers, banks and other providers charge you. However, it is important to understand that foreign exchange rates have just as much of an impact on your margins.

There are several hedging solutions in place to prevent your business from seeing foreign exchange cost fluctuate due to market uncertainty. We saw inflation last year in Europe have a terrible impact on European businesses, with gas prices multiplied by 5 during the summer, leading the US Dollar to be stronger than the Euro for the first time in over 20 years. This is a disaster for businesses who saw a 20% increase in cost due to foreign exchange movements, one which could easily be avoidable with a robust hedging strategy in place.

At GPS Capital Markets, we aim to mitigate these risks as much as possible for you. We have cash-flow hedging tools, IC netting tools, balance sheet hedging tools, as well as an FX treasury management solution platform to help keep track of your cash flow at risk (CFaR) and keep your overall FX gains/losses to a minimum.