Investor watch: inflation and interest rates
Interest rates historically move in the same direction as inflation because central banks rely on interest rates as their primary tool to control rising prices. When inflation increases and consumer demand remains strong, the central bank can slow economic activity by raising borrowing costs.
Higher interest rates reduce spending and investment, which helps contain inflation. Conversely, when inflation declines and economic growth weakens, the central bank may lower interest rates to stimulate demand and support economic activity.
Recent inflation data showing consumer prices rising to 4.1 percent suggest that the economy may be entering another phase of rising prices. While this level is not yet alarming, the trajectory of inflation has become increasingly important because of developments in global energy markets.
Because the Philippines imports most of its energy requirements, sustained increases in oil prices tend to translate quickly into higher domestic inflation through rising transportation costs, electricity prices and eventually food prices.
If global oil prices remain elevated for an extended period, inflation could move toward 6 percent in the coming months. When inflation begins to move in that direction, interest rates usually follow.
Nearly a century ago, economist Irving Fisher developed a theory that explains how inflation affects interest rates. This principle is now known as the Fisher equation.
Fisher proposed that the nominal interest rate consists of two components: the real interest rate and inflation. In simple terms, the nominal rate equals the real return required by investors plus expected inflation. When inflation rises, nominal interest rates must also increase to preserve purchasing power.
If we examine the difference between the 10-year Philippine government bond yield and inflation since 2000, the real interest rate over the past 25 years averages about 1.7 percent. This suggests that investors historically require a real return of roughly 1.5 to 2 percent above inflation.
Using this historical benchmark, we can estimate how nominal interest rates might adjust if inflation continues to rise. If inflation stabilizes at around 4 percent, the Fisher relationship suggests that long-term interest rates would settle near 5.7 percent, assuming a real interest rate of 1.7 percent.
However, if inflation rises toward 6 percent, the same framework implies long-term interest rates of about 7.7 percent. While these estimates are not precise forecasts, they illustrate how higher inflation tends to push nominal interest rates higher over time.
The 10-year government bond yield is a key indicator of long-term interest rates because it reflects market expectations about inflation and monetary policy. It also serves as the risk-free benchmark used to value financial assets, including stocks.
Because equities represent claims on future corporate earnings, higher bond yields raise the discount rate applied to those earnings. As a result, the present value of those earnings declines, which tends to compress equity valuations.
Historical market data suggest that movements in the 10-year government bond yield have a significant inverse relationship with the Philippine Stock Exchange index (PSEi), with a correlation of about 48 percent. This means that when long-term interest rates rise, stock market returns tend to weaken.
For example, when inflation rose above 6 percent in 2018, the central bank raised policy rates by 175 basis points, and the PSEi fell from an intra-year high of about 9,078 to around 6,800 by October. This pattern happened again in 2022 right after the pandemic. When inflation reached 8.1 percent, the central bank responded with aggressive tightening, and the PSEi declined from about 7,500 early in the year to below 6,000 by September.
The next question is how the Bangko Sentral ng Pilipinas might respond if inflation continues rising. The BSP operates under an inflation-targeting framework with a target range of 2 to 4 percent.
When inflation rises significantly above this band, policymakers typically respond by tightening monetary policy through increases in the benchmark rate known as the BSP Overnight Reverse Repurchase (RRP) rate. The Target RRP rate currently stands at 4.5 percent.
This policy reaction has appeared repeatedly during major inflation episodes over the past two decades. When inflation rises well above target, interest rates eventually increase to restore price stability and anchor inflation expectations.
If inflation continues rising because of higher oil prices, the economy may once again face tighter financial conditions. Using the Fisher framework, rising inflation leads to higher nominal interest rates, which may put downward pressure on stock prices.
For investors, the key question is how markets will adjust if inflation continues to rise. Periods of uncertainty such as this often create both risks and opportunities.
Higher interest rates tend to improve yields on government securities and money market instruments, while equity markets may face pressure from tighter financial conditions. However, lower stock prices may create opportunities for long-term investors to acquire quality companies at more attractive valuations.
Henry Ong is a Registered Financial Planner of RFP Philippines. To learn more about investment planning, attend 116th batch of RFP Program this May. To register, e-mail at info@rfp.ph
