Inflation and Interest rates are in a relationship?

Last week, the Government of India released Inflation figures for the month of August about which we talked in our postweek report. Previously, we’ve also done a breakdown of Inflation and its importance. To further our goal of making the financial markets and the ecosystem as simple as possible, we thought of covering a topic that is not talked about as often, mostly because it is misunderstood as complicated. For what it’s worth, it’s not! Let’s try to understand the relationship between Inflation and Interest Rates and why you should care about their chemistry (or the lack of it).

Before we get to the relationship between these 2 important macro variables, let’s understand inflation briefly…

Inflation – A brief overview

Inflation, as you might already know, is the rate at which prices increase over a specific period of time. The next natural question is prices of what, though? The price referred to over here is the average price of almost all consumer goods and services. This includes food and beverages, clothing and footwear, fuel and light, etc. So the government compares how much a basket of all these goods and services cost some time ago as compared to today to come up with the inflation rate of that period. So a 5% annual inflation rate suggests that if a basket of consumer goods cost ₹100 a year ago, then today the same basket will cost ₹105. Also, rising prices are a sign that demand for goods and services is exceeding the supply of goods and services – which also means that too much money is chasing a fewer number of goods… and that causes a rise in prices. Thus, because demand is higher than supply, sellers are incentivised to charge higher prices, which causes a rise in inflation rates.

Okay, so that was a brief on inflation. Now let’s get one misconception out of the way… inflation isn’t always a bad thing. In fact, a nominal amount of inflation (of about 3-5%) for a growing economy is a healthy sign. It signifies that consumers are willing to spend money on goods and services rather than save money. And spending is important for economic growth. However, too much inflation can be very fatal for the economy as well. Because in a high inflation environment, the value of money – as measured by the number of goods and services that can be bought – reduces. To understand this, let’s take an example. Let’s say that a single packet of chips costs ₹10 and hence if you have a ₹20 note with you, you can buy 2 packets of chips. Let’s assume that the rate of inflation that year is 100% (i.e. prices double in 1 year). This would mean that in 1 year, 1 packet of chips will cost ₹20. So that year, you will be able to buy only 1 packet of chips (with ₹20, rather than 2 packets like you could buy the year before). Hence, inflation reduces the number of goods and services you can purchase over time and very high levels of inflation can be extremely fatal for the economy.

Inflation and Interest rates – the Chemistry (or not)

This gets us to our main point of discussion. You see, by now we know that inflation is important but only the right amount of it. And it’s the central bank’s job to keep a check on inflation. How does it aim to do that? If you haven’t already guessed – interest rates! Among other things, one of the main tools that central banks use to keep the price levels (and hence, inflation) in check is interest rates. The government sets benchmark interest rates according to how the inflation in the economy is behaving… Let’s understand how. 

Recessions are primarily characterised by falling incomes, hence falling spending and investment, which eventually leads to falling GDP growth. Due to this, inflation also falls – since demand is weak. In such a situation, it’s the central bank’s job to step in to get the economy back on track. This is when the RBI would decide to lower interest rates. Let’s look at how 2 sets of people behave when interest rates are lowered – individuals like you and me, and businesses. Well, for people like you and me, when interest rates are lowered, we are less likely to save. That’s because banks will pay us lower interest on our savings than they previously did. So we would prefer to spend that money instead of saving. Moreover, businesses will be incentivised to borrow money (since interest rates have reduced) and in turn invest it in their business. Hence, when interest rates are lowered, spending and investments rise, which means demand for goods and services also rise, and that causes inflation to go up to desirable levels.

Now, let’s say the RBI raises interest rates. As individuals, we would rather save money (since the returns would be higher) and businesses would rather not borrow money since the cost of borrowing has increased. This would create a situation where spending, investment and hence demand all fall. This would lower inflation rates.

In a nutshell…

Therefore, inflation and interest rates are theoretically inversely related – that is, they go in opposite directions. When an economy is in recession, central banks around the world lower interest rates to incentivize spending and investment which eventually causes inflation to rise and that helps the economy to get back on track. On the other hand, when inflation is very high and the economy is getting overheated, central banks raise interest rates to disincentivize spending and investment, which helps in lowering inflation – in turn cooling down an otherwise overheated economy.

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