How interest rates affect your investments

Gary Rabbior is the president of the Canadian Foundation for Economic Education. This is the last of a six-part series on understanding how the economy works and why it matters to investors.

To understand why investors should care about how Canada's money is managed, there are a number of key things to note.

One, if there are signs of inflation growing in our economy, then investors should be aware that is it likely that interest rates will start to rise. This will happen for two reasons. First, lenders will want to start protecting themselves against the erosive effects of inflation - so they will start to add an "inflation premium" to interest rates.

Second, if the Bank of Canada appears concerned about the rising rate of inflation, then it will start to try and push interest rates up to dampen spending, borrowing, and demand to try and cool off the inflationary pressures.

So, if it looks like there may be "too much money and too much spending" ahead, investors should consider possible higher interest rates in their decisions.

Consider the current situation. Interest rates are at virtually a historic low. There has been unprecedented government stimulus spending to try and boost the economy. As the economy recovers, and with all that government spending in the system, there is a possibility that spending may overheat the economy. Managing the reduction and removal of the stimulus spending will be difficult for governments and, if it is not managed well, rising inflation could be unleashed. With signs of that - and with signs of a recovering economy - the Bank of Canada may start to move rates higher to try and keep a lid on the increases in spending, borrowing, and demand in the economy. Conclusion - within the year, interest rates should start to rise. How fast and how high they may rise will depend on the rate of increase in spending and prices in the economy.

If there are signs of a sagging economy, then one can look to a decrease in interest rates - or for low interest rates to stay low. For example, some people talk about how fragile the current recovery is. There is talk of a possible "double-dip" recession - that is, some recovery and then another turn down. But if events did unfold that indicated that the economy may take a turn down, then one could assume that interest rates will continue to stay low for some time.

If the value of the Canadian dollar should rise to where the Bank of Canada is expressing concern, this is a sign that the demand for Canadians dollars - to buy our exports, to invest in Canada, to speculate on the value of the Canadian dollar, etc. - is high relative to the supply. The Bank can try and increase the supply of Canadian dollars by buying up foreign currencies with Canadian dollars. It could also try and reduce the demand for our dollar - perhaps by lowering interest rates. But that would be hard for the Bank to do at this time due to how low interest rates are.

If the value of the dollar should start to fall to where the Bank gets concerned, then the Bank may take actions to try and boost its value. Why would the Bank be concerned about a low valued dollar? One reason might be because it would push up the cost of imports to Canadians which can help fuel inflation. A falling dollar would be a sign that the demand for the dollar in exchange markets is relatively low compared with the supply. To boost the value of the dollar, the Bank may try and reduce the supply (e.g. using reserves to buy up Canadian dollars) or it could raise interest rates to attract foreign investment looking for a higher return - or speculating that the dollar`s value is going to rise because of actions by the Bank of Canada.

The Bank of Canada could, then, take actions at various times to try and ensure that monetary conditions are appropriate for the Canadian economy and try and ensure that the rate of inflation stays within its target range. The Bank will aim to manage monetary conditions to support growth as it occurs in the Canadian economy and to boost spending if the economy looks like it may be turning down or heading to recession.

The Bank will also look to protect the international value of our money and try and ensure that the exchange rate for the Canadian dollar is consistent with economic conditions and the health and status of Canada`s economy.

The actions taken by the Bank of Canada can affect the rate of inflation, inflation expectations, and interest rates - and all of these are important factors for investors to consider. Inflation erodes returns on investments and the higher the rate of inflation, the more challenging it is to earn attractive real rates of return.

Changes in interest rates affect stock prices, bond prices, and the value of many other investments. Having an understanding of how our money is managed in Canada - and what the Bank of Canada is trying to achieve - and what it may do to try and achieve its goals - are all important for investors to understand.

A key thing to note is the importance of inflation expectations. As many investors know, those who make investments and affect the market value of investments, try to look ahead. Investors will try and buy the stock of a company that is going to do well in the future. They will try and sell the stock of a company that is not going to do well in the future. That is where the old adage `buy on rumour, sell on news` comes from. It really means that many investors try and buy or sell on the anticipation of what will happen - not what is happening at the moment. That is why a company can increase profits by 20 per cent but still have its stock price fall - investors may have been expecting 30 per cent - and so they sell the stock on the disappointing news.

The same thing applies to inflation and interest rates. Investors will often buy and sell investments based on their expectations of what is going to happen in the future with interest rates and the rate of inflation. That is why it can be harder for smaller, less informed investors. They may not have access to the information and analysis that larger investors have.

In conclusion, we'd like to put in a little pitch for economic education. Financial education and financial literacy are important - but so is economic education we believe. For example, a person can learn what a mortgage is but, without some economic understanding to be able to have a sense of what is happening with interest rates - and what may happen in the future - it is very difficult to make some of the important mortgage decisions. That is why some Canadians back in the 1980s locked into mortgages for five years at 22 per cent. A little economic education would have enabled them to know that such rates were not sustainable and that they were being used to bring down the rate of inflation.

Therefore, with all the talk of financial education and financial literacy these days, we would also like to put in a word on behalf of the importance of economic education. To build a successful economic life, one faces many decisions that can be improved with a little economic understanding stirred in. It isn`t all that hard - and we hope that similar efforts are undertaken to improve economic literacy to help Canadians with the challenges of building a better future - for themselves, for their families, their communities - and this country.