How Inflation triggers the rise in Interest Rates

To counter inflation, the Federal Reserve must increase short-term borrowing rates, which leads to banks increasing interest rates on consumer and business loans. And if you have purchased a house lately, you have seen how much this has impacted mortgage rates and payments.  The purpose of the rate increases is to reduce the amount of demand (business and consumer spending) that drives inflation higher.  When the cost of borrowing goes up, people and business can’t borrow more because they must account for a higher payment, which means less money to spend on items such as cars, big appliances, and mortgages.

Steps to Protect Your Finances Against Inflation

While you can’t hide from inflation, there are ways you can fortify your finances to mitigate its effects and even get ahead of it. 

– Convert Variable Debt to Fixed

Borrowers with variable-rate debt are feeling the impact of rising interest rates because lenders are increasing interest rates. Rates on credit cards, adjustable-rate mortgages, and some personal loans are a few areas that have seen rate increases. You could consider locking in your payments by switching your variable-rate debt to fixed-rate debt. Although interest on fixed-rate mortgages have increased, for many they are still low enough to benefit from an adjustable-rate conversion. If you’re carrying credit card debt, you should try to pay it down as soon as possible or replace it with a fixed-rate personal loan. 

– Accelerate Large Purchases

Prices of durable goods have risen over the past year, but if high inflation persists, they can be expected to continue to increase. If you have been planning on purchasing a big-ticket item, such as a large appliance, car, or home improvement, you could be better off making that purchase now to avoid paying higher prices for the same item in the future.

– Invest in Hard Assets

Assets such as real estate and commodities are assets that benefit from inflation—meaning their value rises in tandem with inflation, sometimes even outperforming it.   Real estate is a good inflation hedge because landlords can always increase their rents, increasing the property’s value.  If you’re reluctant to own real properties, you can benefit from the same effect by investing in real estate investment trusts (REITs).

Commodities such as energy products, industrial and precious metals are also a good inflation hedge. However, they can be volatile investments over time, so you may want to limit your exposure to commodities. 

– Add TIPS to Your Portfolio

TIPS, or Treasury Inflation-Protection Securities, are government-backed bonds that adjust their rate based on the Consumer Price Index. The higher the rate of inflation, the higher your yield. 

– Don’t Keep Your Money in Cash

You should always have enough cash (liquid savings) on hand to cover emergency expenses. But once you have enough saved for your emergency fund (6 months of expenses), keeping additional money in cash can be counterproductive.   While cash may feel safe, how safe is it when you are losing purchasing power every single day?

For example, if you are earning 2% on your cash, but inflation is 7%, you are losing 5% of the value of that money.   Inflation forces you to put your money to work.  As an alternative, consider diversifying your investments among high-quality, dividend-paying stocks that tend to perform well even in times of inflation. You can find low-cost exchange-traded funds that invest in portfolios of blue-chip stocks. 

While it’s impossible to avoid the ravages of high inflation completely, you can mitigate its impact by fortifying your finances. It would be essential to work with your financial advisor to conduct a thorough assessment of your finances and where you can take some reasonable steps to help you come out stronger on the other end.