Three Economic Rates that Matter: Inflation, Interest and Exchange - dummies

Three Economic Rates that Matter: Inflation, Interest and Exchange

By David Stevenson

Crucial to the subject of economic cycles are three simple rates and their impact on the wider economy and thus financial markets in the UK and around the world: the inflation rate, the interest rate and the currency exchange rate.

Inflation rate

The inflation rate, usually given by the retail prices or consumer prices indices, simply measures the change in prices of a basket of goods, services and, in some limited cases, assets. In simple terms, a sharp increase in inflation rates generally tends to indicate that an economy is operating near its current capacity.

That spike in prices is usually very bad news for investors in conventional bonds, including government securities. These have a fixed rate of interest and so any increase in inflation rates blunts that income, putting off potential buyers and generally lowering the real, inflation-adjusted price of the financial asset.

For shares, the picture is slightly muddier because some equity sectors tend to benefit from rising prices (especially those based around resources) whereas most other sectors tend eventually to be hurt badly in terms of profits by rising inflation.

Interest and exchange rates

A sharp rise in inflation rates usually has two distinct knock-on effects on the interest rate and the currency rate. As central bankers become more worried about rising prices, they push up interest rates, forcing a slowdown in the economy and a sudden collapse in the price of shares.

This sudden spike in interest rates is better news for bond investors because the result is a general scramble to move into safer government securities that pay a pre-determined interest rate.

Increasing inflation is also bad news for the currency exchange rates of a country. Increasing prices tend to deter outside investors who worry that they’re invested in a veritable disaster of a country and currency. They start selling that currency, pushing down the exchange rate, increasing local inflation rates even more (although exports become cheaper) and trapping a country into a fast-deteriorating situation.