Best Explanation for Interest Rates and Inflation

The cost of living and borrowing is like a seesaw with each at the tail end. Inflation and interest rates are two economic forces constantly tugging and pulling at each other.

If you have felt like your money is slowly shrinking like a forgotten sock in the dryer, it is an effect of this war between these economic forces.

In 1946, inflation reached a staggering 21,000% in Hungary making it the worst intense on record. Most countries now aim to maintain a 2-3% inflation rate to curb the effect of high inflation rates.

You may be wondering what exactly is the relationship between inflation and interest rates. This article is the best explanation for interest rates and inflation. See how they affect your grocery list and borrowing power.

What is Interest Rate?

An interest rate is the price you pay for borrowing money, expressed as a percentage of the total amount you borrow (the principal).

It’s like the “rental fee” you pay to the lender for using their money. In clearer terms, interest rates are like dance music: They set the tempo for the economy. 

Higher rates, like a fast salsa, encourage saving and discourage borrowing, potentially leading to slower growth. Lower rates, akin to a smooth waltz, grease the wheels of spending and borrowing, potentially boosting growth but also risking inflation.

In practical terms, if you borrow $100 from a friend, they charge you 10% interest. This means you’d pay them back $110 in total – $100 for the principal and $10 for the interest.

They have a significant impact on your finances. Higher rates mean you pay more for borrowing, while lower rates mean you earn more on savings. They come in various forms like mortgage rates, credit card rates, car loan rates, and savings account interest rates.

The interest rate on a loan or deposit is significantly influenced by various factors, including the borrower’s creditworthiness, the loan term, the type of loan, and current economic conditions.

Read Also: What is Sellers Assist? How Does it Work

What is the Inflation Rate?

The inflation rate is the percentage change in the price of a basket of goods and services over a specific period, typically a year.

In simpler terms, it is the sneaky thief slowly shrinking your purchasing power over time. Let’s say you got your favorite latte for $3 in January. By August when you visit to get the same cup of latte, it now costs a whopping $7.

It is all the handiwork of the mischievous economic concept – inflation rate. In practical terms, inflation tells you how much more expensive things are getting on average compared to the previous period. A 3% inflation rate means prices, on average, are 3% higher than they were a year ago.

 As prices rise, your hard-earned money buys less. That $10 you used to spend on groceries might only get you 9 items now. Hurst right?

Well, it is greatly influenced by the law of demand and supply.  If there’s too much money chasing too few goods, prices tend to go up. Similarly, disruptions in supply chains, rising energy costs, and even government policies can contribute to inflation.

Read Also: How Cost of Living Raises Work

What is the relationship between inflation and interest rates?

Let’s say they are dancers on the economic stage with their dancing steps interwoven. Basically, interest rates are used by central banks to manage inflation.

Central banks set the interest rate tempo. They raise or lower rates to influence economic activity and inflation.

When inflation rises too high, central banks raise interest rates. This makes borrowing money more expensive, which discourages spending and investment.

As a result, the demand for goods and services decreases, leading to a slowdown in economic activity and eventually, a cooling down of inflation.

The opposite happens when inflation is too low. Central banks lower interest rates, making borrowing cheaper and encouraging spending and investment. This boosts economic activity and pushes inflation back up towards the desired target.

Sometimes, interest rates might not immediately impact inflation, as the effects can take time to filter through the economy.

Central banks constantly walk a tightrope, they use these two economic concepts to keep inflation under control while also promoting economic growth. In practical terms, when next you mount a pot of water over your hot stove top; visualize inflation as the boiling water, and interest rates are the knob that controls the heat.

You are acting as the central bank. By adjusting the knob (interest rates), you can prevent the water (inflation) from overflowing.

Read Also: 25 Best Gig Economy Jobs & Apps | Starter’s Guide

How does inflation affect real interest rates?

Inflation and real interest rates are intertwined in a dance, but it’s not always a graceful waltz. The Fisher effect is a term that explains the difference between the nominal interest rate and the expected inflation rate.

The Fisher effect states that the real interest rate (the difference between the nominal interest rate and the expected inflation rate) is what truly matters for investment and economic activity.

For instance,

• You borrow $100 with a 5% nominal interest rate (the advertised rate).
• If inflation is 2%, your purchasing power falls by 2% because things cost more.
• So, your real return on the loan is 3% (5% – 2%).

This means, that when inflation is high, the nominal interest rate needs to be even higher to compensate for the loss of purchasing power. Otherwise, the real interest rate would be negative, discouraging borrowing and investment.

On the other hand, low inflation allows for lower nominal interest rates while maintaining a positive real interest rate. This can stimulate borrowing and investment, boosting economic activity.

Unfortunately, predicting inflation accurately is tricky, so central banks face a challenge in setting the right nominal interest rate. If they underestimate inflation, the real interest rate can become negative, harming economic growth.

However, if they overestimate inflation, the economy might suffer due to unnecessarily high borrowing costs.

Read Also: Money on My Mind: How Does Wealth Impact Our Well-Being?

How to calculate real interest rates with nominal and inflation?

To ensure accuracy, you can use a calculator or spreadsheet software to perform the calculations. The formula for calculating the real interest rate is:

r = (1 + nominal_rate) / (1 + inflation_rate) – 1. Where:

• r is the real interest rate (percentage)
• nominal_rate is the nominal interest rate (percentage)
• inflation_rate is the inflation rate (percentage)

If you have a loan with a nominal interest rate of 5% and the current inflation rate is 2%. The real interest rate will be calculated thus:

r = (1 + 0.05) / (1 + 0.02) – 1

r ≈ 0.0294, or 2.94% (rounded to two decimal places).

Why do interest rates rise with inflation?

Interest rates rise with inflation for an important reason: to combat the negative effects of inflation and prevent it from spiraling out of control. Some other reasons that explain why interest rates rise with inflation include:

• To cool down demand: Central banks use interest rate hikes as a tool to dampen demand. By making borrowing more expensive, they discourage people from taking out loans and spending, ultimately reducing overall demand in the economy.

• 2. To protect the value of the currency: Inflation can erode the purchasing power of a currency. Higher interest rates make holding onto the currency more attractive, as it generates a higher return. This incentivizes people to save and invest rather than spend, reducing the circulation of money and mitigating inflationary pressures.

• 3. To maintain economic stability: Central banks have a mandate to maintain price stability and economic growth. Uncontrolled inflation can destabilize the economy, leading to higher unemployment, reduced investment, and overall economic uncertainty. By raising interest rates, central banks aim to bring inflation under control, fostering a stable environment for economic growth.

• 4. To signal their commitment to fighting inflation: Raising interest rates sends a strong message to the market that the central bank is taking inflation seriously and is prepared to take action to bring it under control.

• 5. To prevent a wage-price spiral: In some cases, excessive inflation can lead to a wage-price spiral. As prices rise, workers demand higher wages to maintain their purchasing power. Businesses then raise prices further to cover the increased labor costs, further fueling inflation. By raising interest rates, central banks aim to break this cycle by making it more expensive for businesses to borrow and invest, reducing their incentive to raise wages and prices.

Read Also: 20 Personal Finance Excel Template | Best List

How does rising inflation and interest rates affect pension funds?

Rising inflation and interest rates can have both positive and negative impacts on pension funds. This can affect both the value of their assets and the obligations they owe to their members.

Higher interest rates can benefit pension funds with significant holdings in fixed-income assets like bonds, as the value of these assets typically rises when rates go up.

Also, inflation can boost the value of some assets, particularly real estate, and certain equities, which can benefit pension funds with diversified portfolios.

On the other hand, rising inflation can erode the purchasing power of future pension payments, as the value of a fixed income stream decreases when prices rise. Higher interest rates can also lead to losses on certain investments, particularly those with longer maturities, as their current value falls when rates increase.

Its impact on pensioners’ liabilities can be felt as higher interest rates help discount the present value of future pension obligations, making the overall financial burden on the pension fund appear smaller.

Sadly, rising inflation can increase the cost of future pension payments, as the value of the promised benefits grows faster when prices rise.  The combined impact of rising inflation and interest rates on assets and liabilities will ultimately determine the solvency of a pension fund

In some cases, pension funds may need to adjust benefit levels or increase eligibility requirements to ensure their long-term financial sustainability.

What is the impact of inflation and rising interest rates on my current and future loans and savings?

When interest rates climb, borrowing becomes pricier. You’ll face higher rates on new loans and may even qualify for smaller loan amounts. Existing loans are also affected, but the impact depends on their type: fixed-rate loans stay the same, while variable-rate loans see their payments increase.

On the flip side, your savings might grow as banks offer higher interest rates on savings accounts. However, remember that inflation can erode the purchasing power of your money. To truly benefit from higher savings rates, you need a positive real interest rate, meaning the interest earned outpaces inflation.

Also, banks may offer higher interest rates on savings accounts in response to rising interest rates. This can be a good opportunity to grow your savings. However, inflation reduces the value of your money over time. Even if your savings grow with interest, they might not be able to buy as much in the future.

To combat this effect, consider refinancing fixed-rate loans if rates have fallen significantly. For variable-rate loans, prepare for potential payment increases and build a buffer in your budget.

Aim to save more to compensate for the effects of inflation and potentially benefit from higher interest rates and consider investing in inflation-protected assets like Treasury Inflation-Protected Securities (TIPS) to hedge against rising prices.

Do banks make more money when interest rates rise?

Yes, a rise in interest rates automatically boosts a bank’s earnings. However, this does not come with potential risks.  Banks borrow money at lower rates (deposits) and lend it out at higher rates (loans).

When interest rates rise, the spread between these rates widens, leading to higher net interest income for the bank. This can boost their profits, especially if they have a significant portfolio of fixed-rate loans.

Also, banks can benefit from lower costs when it comes to funding their operations. When interest rates rise, they may offer higher interest rates on savings accounts and certificates of deposit (CDs), attracting more deposits and reducing the need for expensive short-term borrowing.

On the flip side, higher interest rates can discourage borrowing, as it becomes more expensive for individuals and businesses to take out loans. This can lead to lower loan volumes and decreased income from loan interest.

Also, banks with a significant portfolio of variable-rate loans may face higher funding costs if they need to raise rates to match rising market rates. Rising interest rates can also lead to increased market volatility, which can negatively impact the value of the bank’s investments and derivatives, potentially leading to losses.

While rising interest rates can provide some benefits for banks, the net impact depends on their specific business model, loan portfolio, and investment strategies.

Frequently Asked Questions

Conclusion

The relationship between interest rates and inflation shapes our economic landscape. It influences everything from loan payments to grocery bills.

While rising interest rates can cool down demand, combat inflation, and potentially benefit savers, inflation eats away at purchasing power, erodes savings, and can disproportionately impact low-income individuals. 

This article explains the relationship between interest rates and inflation in the best possible way. You should read through it to gain clarity on the economic terms.

References

• Investopedia.com – What Is the Relationship Between Inflation and Interest Rates?
• Esma. Europa. eu – HOW DO INFLATION AND THE RISE IN INTEREST RATES AFFECT MY MONEY?
• Marcus.co.Uk – What’s the difference between interest and inflation?

Recommendations

• How To Fill Out A Money Order Easy Step-by-Step Guide
• How Are Lawsuit Settlements Taxed?
• How to Profit From Inflation: Investment Options
• How Does Money Counterfeiting Works? | Print Counterfeit Money
• How Much Gold is There in the World? Major Gold Mines