Rate Hikes: Interest Rates vs. Inflation1. Introduction: The Relationship Between Interest Rates and Inflation
At its core, inflation refers to the sustained rise in the general price level of goods and services in an economy over time. When prices rise faster than incomes, purchasing power declines, impacting consumers, businesses, and investors.
Interest rates, on the other hand, represent the cost of borrowing money or the reward for saving. Central banks, like the Federal Reserve (US), Reserve Bank of India (RBI), or European Central Bank (ECB), manipulate policy interest rates to influence economic activity.
Key relationship:
When inflation rises beyond the central bank’s target, interest rates are often increased (a process called a “rate hike”) to curb spending and borrowing.
Conversely, during periods of low inflation or deflation, central banks may lower interest rates to stimulate demand.
2. How Central Banks Use Rate Hikes to Control Inflation
2.1 The Mechanism of Monetary Policy
Central banks influence inflation primarily through monetary policy tools. Rate hikes are part of tightening monetary policy, which affects the economy in several ways:
Borrowing Costs Increase: Higher interest rates make loans for businesses and consumers more expensive. This reduces spending on big-ticket items like houses, cars, and capital investments.
Savings Become Attractive: As banks offer higher returns on deposits, consumers may save more and spend less, reducing aggregate demand.
Currency Appreciation: Higher rates often attract foreign capital, strengthening the domestic currency. A stronger currency makes imports cheaper, which can reduce imported inflation.
Expectations Management: Rate hikes signal the central bank’s commitment to controlling inflation, which can influence wage negotiations, business pricing decisions, and consumer behavior.
2.2 Transmission Mechanism
The impact of rate hikes on inflation is not instantaneous. It passes through the economy via the interest rate transmission mechanism, which works through:
Credit channel: Expensive credit discourages borrowing.
Asset price channel: Rising rates reduce stock and real estate valuations, leading to lower wealth effect and reduced spending.
Exchange rate channel: Higher rates attract capital inflows, boosting the currency, reducing import costs, and easing inflation.
Typically, the full impact of a rate hike is observed over 12–24 months.
3. Types of Inflation and Rate Hikes
Not all inflation is the same, and the effectiveness of interest rate hikes depends on the source of inflation:
3.1 Demand-Pull Inflation
Occurs when aggregate demand exceeds supply.
Example: Booming economy with high consumer spending.
Rate hike effect: Very effective, as higher borrowing costs reduce spending.
3.2 Cost-Push Inflation
Occurs when production costs rise, e.g., due to higher wages, oil prices, or supply chain disruptions.
Rate hike effect: Less effective, as inflation is supply-driven rather than demand-driven.
3.3 Built-in Inflation
Caused by adaptive expectations, where past inflation influences future wage and price increases.
Rate hike effect: Moderate, but signaling by the central bank can anchor inflation expectations.
4. Historical Perspective on Rate Hikes and Inflation
Studying historical trends helps illustrate how interest rate adjustments influence inflation:
4.1 US Experience
1970s: Stagflation with double-digit inflation. The Fed raised rates sharply under Paul Volcker, with the federal funds rate peaking at ~20%. Inflation eventually came under control, but the economy experienced a severe recession.
2000s–2020s: Post-2008 financial crisis, rates were near zero to stimulate the economy. Inflation remained low, demonstrating that low rates don’t always trigger high inflation if other conditions (like excess capacity) persist.
4.2 Indian Experience
RBI uses repo rates to manage inflation, targeting CPI (Consumer Price Index) inflation around 4% ±2%.
Example: During 2010–2013, high food and fuel inflation prompted the RBI to raise repo rates to curb prices, stabilizing inflation over time.
4.3 Emerging Markets
Rate hikes in emerging markets often have the dual objective of controlling inflation and maintaining currency stability.
Over-tightening can trigger slowdowns, especially in economies with high debt levels.
5. Rate Hikes vs. Economic Growth
While rate hikes are effective in controlling inflation, they have trade-offs:
5.1 Impact on Investment
Higher borrowing costs reduce business investments in new projects.
Stock markets often react negatively, especially for high-debt sectors.
5.2 Impact on Consumers
Loans (housing, education, personal loans) become more expensive, reducing disposable income.
Luxury and discretionary spending decline.
5.3 Risk of Recession
Aggressive rate hikes can slow the economy too much, leading to contraction.
Policymakers must balance inflation control with growth sustainability.
6. Rate Hikes and Financial Markets
Financial markets react dynamically to rate hikes:
6.1 Stock Markets
Typically, rate hikes are bearish for equities as corporate profits may decline due to higher financing costs.
Growth stocks (tech) are more sensitive than value stocks.
6.2 Bond Markets
Bond prices fall as yields rise.
Investors shift to shorter-duration bonds during rate hike cycles.
6.3 Forex Markets
Domestic currency tends to strengthen as higher rates attract foreign capital.
This can impact export competitiveness but reduce import-driven inflation.
6.4 Commodities
Commodities priced in USD may decline as stronger currency reduces local demand.
Gold often falls during rate hikes because it doesn’t yield interest.
7. Rate Hikes in a Global Context
Interest rate policy in one country can influence others:
7.1 Spillover Effects
Higher US rates often lead to capital outflows from emerging markets.
Countries may raise rates in tandem to protect their currency and control inflation.
7.2 Global Inflation Trends
Oil prices, supply chain disruptions, and geopolitical events can override local rate hikes.
Central banks must consider global factors while adjusting rates.
8. Challenges in Managing Inflation Through Rate Hikes
8.1 Lag Effect
Monetary policy effects are delayed; policymakers often act based on inflation expectations rather than current data.
8.2 Supply-Side Constraints
Rate hikes cannot solve inflation caused by supply shortages or geopolitical disruptions.
8.3 Debt Burden
Economies with high corporate or household debt may be more sensitive to rate hikes, risking defaults.
8.4 Policy Communication
Miscommunication can destabilize markets. Clear forward guidance is crucial.
Conclusion
Interest rates and inflation are intricately linked. Rate hikes are a powerful tool to control inflation, but they come with trade-offs for growth, investment, and financial markets.
Key takeaways:
Rate hikes reduce demand and curb inflation but may slow growth.
Demand-pull inflation responds better to rate hikes than supply-driven inflation.
Timing, magnitude, and communication of rate hikes are crucial.
Global interdependencies mean domestic rate policy must consider international factors.
Investors and traders must adapt strategies in response to rate hikes, balancing risk and opportunity.
Ultimately, the goal of rate hikes is stability—stable prices, sustainable growth, and predictable financial markets. Policymakers walk a delicate tightrope, balancing inflation control with the need to foster economic activity, making the study of interest rates versus inflation an essential part of modern finance and economics.
Rates
$US10YR - Potential Double Head & Shoulders Pattern Forming FPMARKETS:US10YR - Potential double head and shoulders pattern on the Daily Chart. This could align with Trump's lower rates initiative. We are seeing some weakness coming into employment data, seems like CPI and PPI are showing progress on inflation. The smaller Head & Shoulders pattern has a measured move to around 4.23% right at the 200 SMA (yellow) and the larger Head & Shoulders pattern measured move is 3.70%. This could take several months to play out since this is a daily chart. All eyes on this Friday's PCE and Non-farm payroll first week of February. I think we will have favorable PCE numbers YoY in February and March which could help the fed take their eyes off inflation and focus on jobs numbers, allowing them to cut. The market is pricing in 1.5 cuts this year. I think we will see 3-4 cuts.
NZDUSD stays on the buyer’s radar on RBNZ dayDespite the RBNZ-led volatility, NZDUSD defends the early month breakout of the 100-DMA and a downward-sloping trend line from April 05. That said, the 38.2% Fibonacci retracement level of the pair’s April-October downturn, near 0.6090, restricts the Kiwi pair’s immediate declines ahead of the aforementioned resistance-turned-support line, close to 0.6040 at the latest. Following that, the 100-DMA and a six-week-old ascending trend line, respectively near 0.6015 and the 0.6000 round figure, could act as the last defenses of the pair buyers before welcoming the bears.
Meanwhile, the pair’s upside momentum needs a daily closing beyond the monthly high surrounding 0.6205 to convince NZDUSD buyers. In that case, the 50% Fibonacci retracement and the 200-DMA, close to 0.6270 and 0.6305 in that order, will be in the spotlight. Should the New Zealand dollar remains firmer beyond the 200-DMA, the 61.8% Fibonacci retracement, also known as the golden ratio, might probe the north-run near 0.6455, a break of which won’t hesitate to challenge the tops marked in May-June around 0.6570-75.
Overall, NZDUSD is likely to remain the bull’s favorite unless breaks the 0.6000 threshold.
RBNZ Rate DecisionReserve Bank Of New Zealand
Interest rate decision:
The Consumer Price Index CPI rose by 7.2% in September 2022, it's fall from August's print but still higher than experts thought which the consensus is 6.5.
Economists expect the Reserve Bank of New Zealand to lift the cash rate by a record 75bps while money markets wager a roughly 65% probability for the biggest ever rate point hike this month.
Guys my take on this rate saga are:
I'm bullish with NZDJPY, NZDUSD, NZDCHF, if the bank increase its OCR by 75bps.
I'm bearish with NZDJPY, NZDUSD, NZDCHF, if the bank increase its OCR by only 50bps.
Because the New Zealand Dollar needs an upward revision to the Bank's rate hike trajectory and Hawkish rhetoric from the governor Adrian Orr to resume it's March towards 0.6250 against US Dollar.
GBPUSD breaks 1.1290 support ahead of BOE announcementsGBPUSD renews 37-year low, breaking four-month-old support line and 61.8% Fibonacci Expansion (FE) of the GBPUSD pair’s moves between August 17 and September 13, close to 1.1290, as traders await the Bank of England’s (BOE) monetary policy updates. Though the cable pair broke the nearby key support, now resistance around 1.1290, oversold RSI conditions and a likely positive surprise from the “Old Lady”, as the BOE is popularly known, tease the Cable pair buyers. In that case, the 5-DMA and a six-week-old resistance line, respectively around 1.1410 and 1.1560, could challenge the bulls. Following that, a one-month-long horizontal resistance area will precede the 50-DMA to restrict the quote’s further upside around 1.1740 and 1.1845 in that order.
Alternatively, the 78.6% Fibonacci Expansion (FE) level near 1.1160 lures the GBPUSD bears unless it stays below 1.1290. In a case where the Cable pair drops below 1.1160, the odds of witnessing a slump towards the 1.1000 psychological magnet can’t be ruled out.
Overall, GBPUSD seemed to have a little downside room ahead of the anticipated hawkish BOE.
AUDUSD pierces 0.7100 on RBA’s rate hikeAUDUSD bulls cheer the Reserve Bank of Australia’s (RBA) 25 basis points (bps) rate hike in early Tuesday. The recovery moves also justify the RSI rebound from oversold territory, as well as pierce a downward sloping resistance line from April 21, near 0.7100 by the press time. Considering the RBA’s hawkish moves, backed by firmer technicals, the Aussie pair is likely rising towards the mid-March swing low surrounding 0.7165. However, the 200-SMA and previous support line from March, around 0.7285 and 0.7410 in that order, will challenge the bulls afterward.
Meanwhile, the pair’s fresh downside may aim for the 0.7040 level before directing the bears towards the 0.7000 psychological magnet. Following that, the yearly bottom surrounding 0.6965 will be in focus as a break of which will direct the AUDUSD bears toward the mid-2020 lows near 0.6775.
Overall, AUDUSD is cheering the well-due recovery as the RBA announced rate-hike. However, the upside momentum needs validation from the Fed before reversing the broadly bearish trend.
Money Continues To Flow Into BondsMonthly Charts force us to take a step back and give us no choice but to identify the direction of the primary trends. We use these charts to put shorter-term trends into context and this exercise is particularly useful when the market is experiencing heightened volatility. This chart is the US 10-Year Note Futures making its highest monthly close, ever. New all-time highs are evidence of an uptrend, not a downtrend. It's clear that money continues to flow into the Bond market despite the strong rebound in stocks over the last month. This is evidence of risk aversion, not risk appetite among market participants. US Rates set the tone for Interest Rates around the world, so the trend we're witnessing here is indicative of the strength we're seeing in Bonds all around the globe.