What is the relationship between inflation and interest rates? By Jean Folger Updated January 3, — Inflation and interest rates are often linked, and frequently referenced in macroeconomics. Inflation refers to the rate at which prices for goods and services rise.
Beginning of content The Relationship Between Bonds and Interest Rates When you buy a bond, either directly or through a mutual fund, you're lending money to the bond's issuer, who promises to pay you back the principal or par value when the loan is due on the bond's maturity date. In the meantime, the issuer also promises to pay you periodic interest payments to compensate you for the use of your money.
The rate at which the issuer pays you—the bond's stated interest rate or coupon rate—is generally fixed at issuance. An inverse relationship When new bonds are issued, they typically carry coupon rates at or close to the prevailing market interest rate.
Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. How does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else?
The answer lies in the concept of opportunity cost. Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond's coupon rate—which, remember, is fixed—becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself.
Let's look at an example. After evaluating your investment alternatives, you decide this is a good deal, so you purchase a bond at its par value: Now let's suppose that later that year, interest rates in general go up.
It would be priced at a premium, since it would be carrying a higher interest rate than what was currently available on the market. But the important thing to remember is that change occurs in market interest rates virtually every day.
The movement of bond prices and bond yields is simply a reaction to that change. The illustration is approximate and is not intended to represent the return of any particular bond or bond fund. Bond values fluctuate in response to the financial condition of individual issuers, changes in interest rates, and general market and economic conditions.In economic theory, if the interest rates in one country increase, then the currency value of that country will increase as a reaction.
If the interest rates decrease, then the opposite effect of depreciating currency value will take place. This relationship forms one of the central tenets of contemporary monetary policy: central banks manipulate short-term interest rates to affect the rate of inflation in the economy.
For instance, if interest rates rise by 1 percent, the price for a bond with a duration of 4 will fall by 4 percent while a bond with a duration of 6 will fall by 6 percent. In economic theory, if the interest rates in one country increase, then the currency value of that country will increase as a reaction.
If the interest rates decrease, then the opposite effect of depreciating currency value will take place. For instance, if interest rates rise by 1 percent, the price for a bond with a duration of 4 will fall by 4 percent while a bond with a duration of 6 will fall by 6 percent.
Rates also rose because the Federal Reserve raised the fed funds rate on December 14, The Fed expects to raise fed funds rate several times in Expect interest rates to .