To understand the relationship between interest rates and by mrleitner


									Interest and Inflation

Craig Chiado Mark Van Gilder BUSA 335 10/12/06


To understand the connection between interest rates and inflation we looked at several relationships from the economic data that was provided to us. The data we examined included Savings vs. Inflation, P/E vs. Inflation, and Inflation vs. S&P 500 index. We also looked at the yield curve to better understand how interest rates are affecting our economy in the short-run and long-run.

Inflation If you look at what news has been dominating business headlines in the past couple of months, the term inflation is likely to be at the top of the list. Inflation is defined as a rise in the general level of prices, as measured against the consumer price index and other economic indicators. Inflation is an important concept, and if understood correctly can help one understand why the economy is acting the way it is. Inflation is most often associated with interest rates. Today, many in the economics field believe that inflation is caused by the interaction of the supply of money with output and interest rates. With rising prices of goods and services, a result is that your dollar loses value, and your purchasing power is decreased. This can be seen when inflation rises, the value of your dollar falls. Accordingly, if inflation rises, the cost of borrowing increases along with interest rates. If you examine economic theory, there seem to be three major types of inflation. The demand pull inflation is when you have a high demand for goods and services with a constant supply, prices will be driven higher. Over the past few years we have seen an increase in oil prices. In the US, we are very dependent on oil. Because of our high dependence on oil, we are willing to pay high prices for oil. Most recently, we have begun to see a decrease in oil prices. Economists believe that the decrease in oil prices will have a direct impact on inflation, possibly


leading to an ease in inflation concerns1. The second type of inflation is cost push inflation. If for some reason, a company experiences a high cost to produce a good, they will pass the extra cost onto the buyer. An example of this type of inflation is the oil crisis of the 1970’s. When the member states of OPEC increased the cost of oil, oil companies passed the increase costs onto the consumer. Since oil is important for developed industrialized economies, a large increase in prices can lead to the increase in the price of some products, thus increasing inflation. This can be seen today as well. With a decrease in petroleum prices, people might see a decrease in airfare along to plastic products which are made from petroleum2. The third part of inflation is the money supply. If a countries money supply is too large, you will find that it is easy and relatively inexpensive to borrow money. Respectively if you have a decreased money supply, it is more difficult and expensive to borrow money, which contributes to an increase in interest rates and ultimately increased inflation

Savings Rate vs. Inflation
Personal Savings Rate vs. Inflation 16 14

Inflation Rate

12 10 8 6 4 2 -2.00 0 0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00

Personal Savings Rate

1 2

The Wall Street Journal 10/05/06 Gasoline Prices Could Fall More The Wall Street Journal 10/05/06 Gasoline Prices Could Fall More 2


The relationship between the savings rate and inflation is positively correlated. As such, when inflation is high it appears that people save more, and when the inflation rate is low people save less. This is due to the fact that when inflation is high people attempt to safeguard their money by putting it into a bank and when inflation is low peoples purchasing power increases and they are more likely to spend their money. This again is related to interest rates. When inflation rises, interest rates will rise and people will be more likely to save at higher interest rates and vise-versa. However, it is very important to note that whatever interest rate you save at, the inflation rate should be lower otherwise you will lose money due to the decrease in purchasing power.

P/E vs. Inflation
P/E vs. Inflation
50.00 45.00 40.00 35.00 30.00 25.00 20.00 15.00 10.00 5.00 0.00 0 2 4 6 8 10 12 14 16 Inflation Rate

It is widely accepted that interest rates and earnings are two fundamental determinants of stock price. The P/E ratio is a valuation of a company’s current share price compared to its pershare earnings. In general, a high P/E suggests that investors are expecting higher earnings growth in the future and are willing to pay the extra buck. However, equity prices are affected by inflation in several ways. When inflation is low, interest rates are low and there is a greater opportunity for higher real earnings growth leading to higher willingness to pay for a company’s



earnings which is realized in increasing P/E. Whereas, when inflation increases, interest rates increase and P/E falls, and in order to maintain their purchasing power investors will require a higher rate of return. This will generally lead them to shift their capital away from the equity market and into the debt market.

Inflation vs. S&P 500 Index When you look at inflation compared to Standard and Poor’s 500 index you can conclude a definite relationship. The Fischer Effect states that as inflation rises so does interest rates; which in turn makes it tougher for firms to gain investment capital. When firms have a decrease in investment capital it hinders company growth, and makes investors tentative to invest due to reduced expectations for future cash flows shown in earnings. This relationship can be boiled down into the simple equation P=E/k, where P is price, E is earnings, and k is the interest rate. If you hold earnings (E) constant and interest rates increase (k) then price (P) must decline. Another way to look at it is if interest rates (k) are high, then earnings (E) are expected to decline, and price (P) will decline again. The best way to perceive this relationship is graphically plotting S&P 500 vs. interest rates.
Price Adjusted S&P 500 vs. Inflation
1800.00 1600.00 1400.00 1200.00 1000.00 800.00 600.00 400.00 200.00 0.00 0 2 4 6 8 Inflation Rate

Price Adjusted S&P 500

y = -265.64Ln(x) + 929.25 R2 = 0.2268






Despite a few outliers at the top of the graph there is definite relationship between Inflation and the S&P 500 index.

Yield Curve The yield curve shows the relationship between the interest rate and the time to maturity of the debt. Basically the yield curve is a graphic representation of countries interest rates. A normal yield curve is when the curve has a positive slope. This positive slope reflects investor expectations for the economy to grow in the future.3 The curve is shaped like this because in the future investors are expecting long term economic growth, and expect to be rewarded for their risks. An example of a normal yield curve is below.

If you look at the US yield curve right now, it is not what we would consider a normal yield curve. Today the US has an inverted yield curve. An inverted curve occurs when long-term yields fall below short-term yields. When an investor sees an inverted yield curve, they should take notice. An inverted curve may indicate a worsening economic situation in the future. Every inverted yield in the US has been followed by a recession. An inverse yield curve predicts lower



interest rates in the future as longer-term bonds are being demanded, sending the yields down.4 An example of an inverted yield curve is below.



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