Summer lovin', had me a blast, summer lovin', happened so fast...

Just like the whirlwind summer beach romance between Danny and Sandy (in the movie Grease), the relationship between inflation and interest rates continues to heat up our ongoing conversations with our clients.

Last summer, we experienced many hot days with the sun blazing high and temperatures rising—much like inflation, where the cost of goods and services steadily rises over time. On days like these, a “dreamy”, refreshing splash of an ice-cold drink is just what is needed to provide relief—this is like the intervention of interest rates, working to cool things down.

When the economy heats up and prices start to soar, central banks, like the Federal Reserve, step in as the lifeguards to provide some aid to the economic climate. They raise interest rates to temper the economic heat, making borrowing more expensive and saving more attractive. It’s a delicate dance that helps to slow down spending and investment, cooling off rapid price increases. It sounds simple in theory, but how does it play out in the real world?

Tell me more, tell me more, did you get very far?

When inflation began to take hold post-COVID, the Federal Reserve was initially slow to respond based on the premise that higher prices were “transitory” and would come back down as supply shortages and labor imbalances worked themselves out. In early 2022, when it was obvious that inflation remained stubbornly high, the Fed finally began raising rates from its target range of 0%-0.25%. Rate increases continued steadily until they peaked in August 2023. It was an astonishing increase of over 5% in less than 18 months, and surely this would cool off an overheating economy and rein in inflation, right? Not so fast.

Just as any relationship has its challenges, the dynamic between inflation and interest rates doesn’t always play out as expected. While the Fed’s dramatic intervention led to prices coming down in 2023 and, subsequently, tremendous stock market growth and a fourth-quarter bond rally, things stalled out heading into 2024, with inflation staying stubbornly high. This led to market turmoil early in the year as the Fed committed to keeping rates higher for longer while investors tried to digest the impact on stock and bond prices.

Tell me more, tell me more. Was it love at first sight?

While bonds have barely stayed above water this year, stock prices have continued to climb, fueled by solid economic growth and AI-driven gains in the technology sector. Even though bonds have struggled mightily over the past few years due to rising rates, yields are now higher than they have been in years, making expected future returns attractive once again.

The markets believe the Fed is likely to begin lowering rates (sooner rather than later), given recent inflation data and other economic indicators. Lower rates usually stimulate economic growth and support higher stock and bond prices, but as the past few years have shown, predicting both the timing of rate changes and their impact on asset prices is incredibly hard.

In the end, the relationship between inflation and interest rates is all about balance, and the Fed is using its tools to keep the economy neither too hot nor too cold, but just right. Like a perfect summer day, it requires just the right mix of sunshine and shade to create a comfortable and enjoyable environment for everyone.