Can Higher Interest Rates Increase Inflation?

We’ve been having an ongoing discussion about commonly cited reasons inflation has become a global phenomenon since 2021. These factors range from the lasting impact of the pandemic to domestic political choices, the war in Ukraine, supply chain disruptions, and beyond. To say it’s complicated is an understatement.

But another, less commonly cited factor in debates about how interest rates and inflation interact may be important: risky bets on startups.

How Low Interest Rates Baited Investors

In recent years, consumer-tech businesses have supported the urban Millennial lifestyle, including ride-hailing, food delivery, fitness, travel, and retail startups. Most apps behind these companies were unprofitable. But because interest rates were low and asset valuations sky-high, these companies raised financing from Venture Capital (VC) and Private Equity (PE) sponsors looking for the next Amazon. 

Such investments are like investing in lottery tickets. That’s not necessarily a sound strategy. We’ve written before about the danger of chasing potential unicorns.

The dynamics in play also encouraged risky behavior within the startups. This environment encouraged the companies to expand aggressively by growing their user base, even if the business was unprofitable.

But now interest rates are on the rise. 

Inside the Global Interest Rate Debate

The Federal Reserve just doubled down on its strategy for addressing the environment with another substantial interest rate hike. Federal Reserve governors’ recent comments indicate they are unlikely to slow down. Yahoo Finance summarized:

Following the Federal Reserve’s super-sized interest rate hike and another hot read on inflation, a slew of Fed speak this week indicated that central bank officials are unified in the task of cooling inflation — even in the face of global market turmoil.

Across statements, the message was clear: The Fed plans to continue raising rates higher and holding them there is “clear and convincing” evidence that inflation is cooling. And while recession risk has risen, it’s not the base case expectation.

[…]

At a research conference in New York on Friday, Fed Governor Lael Brainard underscored that it will take time for the full effect of higher interest rates to work through different sectors and to bring inflation down, adding that the Fed is committed to avoiding pulling back prematurely. Brainard noted that the real yield curve — yields on Treasuries adjusted for inflation — is now in solidly positive territory except for the shortest maturities and with more rate hikes she expects short-term yields to move into positive territory as well.

The Federal Reserve is not the only central bank acting, either. Because of a political move on taxes, a weak British pound, and significant pension funds in peril, the Bank of England announced a controversial bond buyback program to try to stabilize the markets. This spiked a new level of anxiety across the Eurozone about rate hike probabilities. 

In the meantime, a new report from the United Nations Conference on Trade and Development warns that ongoing rate hikes risk a global recession that is most likely to cause pain for vulnerable populations. Put another way: we’re all in trouble, but those VC and PE investors, and the companies they bet on, could fuel the fire.

Can Higher Interest Rates Increase Inflation?

It is important to note that companies whose expected earnings lie primarily in the future have a long duration, and consequently, their valuations are sensitive to changing interest rates. Many of these companies are privately held, making their valuations less transparent. They most likely have fallen — in many cases, sharply. 

VC and PE sponsors are pressuring the companies to improve their profitability, which means increasing prices for the services they provide alongside cost-cutting measures. To the extent the markets they serve will support higher prices, this is manifested as a contribution towards increased inflation, driven by interest rate increases, in a way that would surely make President Recep Tayyip Erdogan of Turkey feel vindicated.

Here’s the bottom line. Now that previous support from VC and PE investors is being dialed back, we will see whether these companies can make a profit in a market undistorted by artificially low rates. It is, however, possible that the market for these services cannot support the higher prices That could mean many companies folding if they are unable to find ways to cut costs. 

Either way, whether consumer-tech companies survive or their failure allows traditional companies to recover pricing power, higher prices are here to stay.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

• Basic Investing Principles 101: From Asset Allocations to Zero Coupon Bonds
• Due Diligence Before Investing
• Help! My Business Is in Trouble

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