As diligent investors know, interest rates historically move in tandem with inflation because central banks rely on rate adjustments as their primary tool to control rising prices. When inflation climbs and consumer demand remains robust, the central bank can cool economic activity by raising borrowing costs.
Higher interest rates dampen spending and investment, helping to contain inflation. Conversely, when inflation falls and economic growth weakens, the central bank may lower rates to stimulate demand and support the economy.
Recent inflation data showing consumer prices rising to 4.1 percent suggest the economy may be entering another phase of rising prices. While this level isn't alarming yet, the trajectory of inflation has become increasingly important due to developments in global energy markets.
Since the Philippines imports most of its energy, sustained increases in oil prices quickly translate into higher domestic inflation through rising transportation costs, electricity prices, and eventually food prices.
If global oil prices stay elevated for an extended period, inflation could approach 6 percent in the coming months. When inflation moves in that direction, interest rates usually follow.
Nearly a century ago, economist Irving Fisher developed the Fisher equation, which explains how inflation affects interest rates. Fisher proposed that the nominal interest rate consists of two components: the real interest rate and expected inflation. When inflation rises, nominal rates must increase to preserve purchasing power.
Historical Benchmark
Examining 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 investors historically require a real return of roughly 1.5 to 2 percent above inflation.
Using this benchmark, if inflation stabilizes around 4 percent, the Fisher relationship suggests long-term interest rates would settle near 5.7 percent, assuming a real rate of 1.7 percent.
However, if inflation rises toward 6 percent, the same framework implies long-term rates of about 7.7 percent. While not precise forecasts, these estimates illustrate how higher inflation tends to push nominal rates higher over time.
The 10-year government bond yield is a key indicator of long-term interest rates, reflecting market expectations about inflation and monetary policy. It also serves as the risk-free benchmark for valuing financial assets, including stocks.