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Inflation, Interest Rates, and You - How Are They Connected?

Inflation, Interest Rates, and You - How Are They Connected?

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Published on 15.07.2022
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By now, you’re probably very aware of the acute rise in the cost of living in Singapore and around the world. And that might have gotten you thinking...inflation, interest rates, what is the connection between these two forces?

To kick you off, check out our previous articles where we explained how inflation works and perhaps more importantly – what you can do about it.

All caught up?

Just as we need to adjust our financial and investment decisions during this period of heightened inflation, national governments and central banks have also made adjustments to their policies decisively.

The most consequential of which was undertaken by the US Federal Reserve.  It announced in June 2022 that its benchmark interest rate would be increased by 75 basis points. This represents the steepest such increase in nearly three decades.

How Increasing Interest Rates Can Help Rein in Inflation

With increased interest rates, borrowing is more expensive, thus reducing the amount of (borrowed) money circulating in the economy. This discourages consumer and business spending in general, including on big-ticket items like properties, capital equipment, and even motor vehicles.

For large publicly-traded companies, higher interest rates also reduce the amount of low-cost funds available to pursue growth. For companies who rely on borrowed funds to expand, this might slow down their trajectory, and consequently diminish their short-term attractiveness to investors.

Does the US Fed’s Interest Rates Affect Interest Rates in Singapore?

While the Fed’s interest rate increase is aimed at slowing inflation in the United States, such a move by the world’s largest and arguably most important economy has profound and far-reaching consequences for the global financial system – including for all of us in Singapore.

After news of the Fed’s rate hike, you might have noticed that rates for various financial instruments in Singapore have correspondingly gone up – including home mortgages and the Singapore Savings Bonds.

According to data from the World Bank, here is the historical chart showing the lending interest rate of the United States and Singapore from 1978 to 2021.

Source: World Bank

From the World Bank data, we can see that the trajectory of interest rates in Singapore mirrors that of the United States – albeit with a lag and in varying magnitudes.

Because of the loose historical correlation, there is a common perception that interest rates in Singapore are somehow pegged or move in tandem with the US Fed benchmark interest rates. However, it is important to emphasise that any observed correlation does not imply causation.

MAS’ Response Towards the Fed Hike and Inflationary Pressures

Unlike the US Fed, Singapore’s central bank and financial regulator, the Monetary Authority of Singapore (MAS), does not use interest rates as an instrument for making monetary policy.

Instead, MAS utilises the nominal exchange rate exclusively as the intermediate target of monetary policy to influence prices throughout our economy. This is done by managing the value of the Singapore Dollar (SGD) against a trade-weighted basket of currencies within the specified policy band, also known as the Singapore Dollar Nominal Effective Exchange Rate (S$NEER).

The target policy band is reviewed every six months (in April and October). In their latest monetary policy review, MAS slightly increased the slope of the S$NEER policy band, giving the Singapore Dollar scope to appreciate at a higher rate.

inflation vs interest rate

MAS stated that this move was made “in view of the upward revision to the MAS Core Inflation forecast amid rapidly accumulating external and domestic cost pressures” in order to “exert a continuing dampening effect on inflation”.

Theoretically, a stronger Singapore Dollar compared to the currencies of her major trading partners reduces the prices (in SGD) of imported goods and services, which should dampen the prices that households in Singapore need to pay.

How Rising Interest Rates Affect the Everyday Person in Singapore

In order to make better financial and investment decisions amid this period of heightened interest rates, we need to understand how changes in these rates affect various parts of our financial life.

Residential properties are probably the most expensive and valuable asset that many people purchase in their lives. The rising interest rate means that it will now be more expensive to purchase a property, which might cause some property hunters to have to lower their budgets.

Existing homeowners with a mortgage might find themselves needing to cough up more money in monthly repayments if or when higher rates kick in on their home loan package.

Since the cost of borrowing across the board will rise, consumers should be very careful about getting into fresh debts. Those with a habit of taking on debt to accelerate life plans or business growth might want to explore other options instead, such as saving up first or getting investors on board.

It is not all doom and gloom though. Increasing interest rates can also cause the value of fixed income bonds issued previously to fall, since newer offerings would look more attractive.

It is not a bad time to invest in newly-issued bonds – if you can get a hold of them, that is. This is because companies and governments might be more cautious in making new bond issuances, given the increased cost of such borrowings.

Those who are more risk-averse might be pleased to see promised returns going up on less-volatile assets like fixed deposits, bonds, cash management accounts, and even high-interest savings accounts. However, some of the inherent drawbacks of these tools still remain – such as poor liquidity and a limited upside.

Time to Re-Evaluate Your Financial Portfolio

National governments raising interest rates to combat inflation has put an end to years of low interest rates. It is timely to re-examine our investment portfolio and financial plan to see whether our existing holdings are still optimal in providing the best risk-adjusted returns to meet our current and future needs.

Naturally, some might seek out higher yields that outpace even a high rate of inflation over time. These include stocks, mutual funds, exchange-traded funds, gold, and more recently – cryptocurrencies.

While capable of producing eye-watering returns over the long-term (think decades), the stock market can be volatile in the near-term (one to five years) and investors who are just seeking to hedge against inflation might not want to take on that additional volatility.

Inflation 101 - Read more in our series

Worried about inflation, or just trying to understand it better?

We've put together a series of articles to help you dive deeper into the subject matter and understand the relationships between interest rates and inflation, what inflation is, inflation in Singapore in 2022, and what you can do about it.

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