Interest rates, inflation, and mutual funds

One morning, the Bank of Canada—protector of Canadians’ purchasing power—raises its key interest rate in order to diminish inflationary pressure. “The major banks are following its lead,” the papers proclaim. What does that mean? And what kind of effect will that have on your mutual funds?

Short and long term interest rates: two realities

Generally, as is the case in Canada and the United States, central banks have direct influence over short term interest rates. Central banks set the key interest rate, or the rate at which other financial institutions will be able to borrow from them. The lower that rate, the more likely that banks will borrow money and, in turn, lend it to their customers, stimulating economic activity. Conversely, if the economy shows signs of overheating, monetary authorities will raise the key interest rate in order to slow spending and put the brakes on rising prices.

As for long term rates, they are determined by the markets. Thus the inflationary expectations of institutional investors—such as pension funds, insurance companies, and mutual fund managers—play an important role in determining long term interest rate trends.


To sum up, the best way to protect against interest rate fluctuations is by having a mix of asset classes in your portfolio.

Inflation: friend or foe?

When prices go down, consumers rejoice! But watch out, because deflation—a widespread drop in prices—is harmful for the economy when consumers, aware that a short and medium term price decrease is imminent, put off their purchases. When consumption decreases, the economy suffers.

Conversely, inflation is a normal consequence of economic prosperity. When business is good, consumers become optimistic about the possibility their salaries will go up. They’re thus willing to pay more for goods and services.

In order to foster Canada’s economic and financial prosperity and avoid an inflationary spiral, the Bank of Canada needs to manage the inflation rate, keeping it just shy of levels that could over-erode consumer purchasing power and thereby endanger the economy.

Equity and alternative investments funds can protect against the effects of inflation

Equity funds	In periods of prosperity, businesses take advantage of rising prices to increase their profits. Over the long run, equity prices usually increase as a function of inflation.
Alternative investments	Prices for certain types of nontraditional investments—such as real estate, consumer staples, and unrefined natural resources (oil, natural gas, gold, silver, wheat, etc.)—increase much more quickly during inflationary periods, which helps protect the purchasing power of investors holding this type of investment. Rising portfolio values can protect their savings from inflation. Unlike conventional bonds, the current return and face value of real return bonds are, for their part, adjusted to the inflation rate, which can protect portfolios against inflation.

Inflation

The annual rate of inflation reflects consumer price index (CPI) fluctuations, comparing a specific month to the same period of the preceding year. Statistics Canada establishes the CPI based on a “basket” of goods and services. The composition of the basket is revised periodically in order to reflect changes in consumer habits.

The Bank of Canada

The Bank of Canada’s role is to “promote the economic and financial welfare of Canada.” Responsibilities: Monetary policy: keeps inflation within a target range (between 1% and 3%) Bank notes: designs, produces, and distributes paper money Financial system: provides liquidity to financial institutions and oversees the payment system Funds management: manages the federal government’s cash balances and borrowing Source: Bank of Canada