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Interest Rates And Cooling Inflation Explained

Inflation shows how living costs have increased in comparison to a past point.

Interest rates usually rise alongside inflation as one of the most effective ways central banks such as the Bank of England (BoE) or the US Federal Reserve can try to stop inflation from becoming out of control.

When baseline interest rates are close to zero, inflation can substantially impact the economy since interest rates, in effect, become negative.

For example, a two per cent inflation rate added to a 0.25 per cent interest rate gives a savings rate of -1.75 per cent. For savers, their spending power is decreasing by 1.75 per cent.

That impact is that gains are transferred from savers to borrowers, resulting in some form of ‘inflation taxation’ to offset the considerable borrowings held by the government.

Instead, governments take action by adjusting interest rates according to the current inflation rates and how these correspond with their targets.

Inflation v Interest Rates

Inflation, as a standalone metric, can be a positive indicator of economic growth and resulting increases in living costs. However, a problem occurs when inflation climbs too quickly and faster than wages.

In this scenario, governments will often raise interest rates to discourage borrowing, encourage people to save more, slow the economy, and bring inflation back to a reasonable level.

The opposite applies if the economy needs a boost, as lower interest rates mean people can borrow more and have a higher income to spend.

Deflation, a sustained decrease in prices, is seen as more dangerous than inflation, so in the US, the Federal Reserve Act targets annual inflation rates of two per cent, which matches the target set by the BoE.

Measuring Inflation

The Consumer Price Index (CPI) is a commonly used inflation indicator and uses the price variations on a standardised basket of goods to identify changes in inflation rates.

Each country uses a different body to manage inflation predictions, but all use a similar approach, collating pricing information from sources such as:

  • Government authorities
  • Property market experts
  • Energy suppliers
  • Supermarkets and retailers
  • Online retail websites

Items selected for price review are picked using weighted volumes to determine the products, services or resources that most people spend their earnings on.

For example, increased usage of smartphones means an increase in the weighted importance lent to the costs of smartphone contracts when calculating the CPI.

Detailed information about household spending is normally collected every few years, so the CPI is more of a broad overview than a highly specific calculation method.

An important factor to remember is that the CPI does not indicate actual price levels. For example, if it shows that eggs have a price index of 150 and bread 180, bread isn’t necessarily more expensive than eggs.

Rather, it means that the price of bread has risen faster than the price of eggs in the year-to-year comparison.

CPI price reviews also calculate changes without determining whether product quality has impacted the perceived value of an item.

If a new product has been introduced to the market and is valued higher, the CPI cannot differentiate between an innovative new product that commands a price premium and the same product that has increased in cost.

Government analysts also refer to other surveys, such as the Personal Consumption Expenditure Price Index (PCE), which monitors responses to consumer spending surveys in the US.

The PCE compares spending and prices paid through business revenue tracking to calculate Gross Domestic Product (GDP).

Underlying Inflation

Although headline inflation garners attention, inflation itself is normally present in any growing economy and is called underlying inflation.

Economists pay equal attention to underlying inflation to build in particularly large fluctuations, either in a specific quarter or keep recurring.

Most of these large changes owe to a temporary indicator such as extreme weather, political instability or sudden changes to tax regimes that have a knock-on impact on consumer spending, supply and demand, or investor attitudes.

Other technical factors can affect inflation, such as volatile items like fresh fruit, which is prone to supply disruptions or commodities that change quickly in value depending on the global oil supply market.

Controlling Inflation With Interest Rates

When a central bank reacts to higher inflation risks by raising benchmark interest rates, it restricts the level of risk-averse funds within the financial ecosystem, which limits the cash available to invest in higher-risk assets.

A lower interest rate has the opposite effect.

These strategies can encourage or discourage consumer and business spending, particularly on higher value expenses such as equipment and housing.

There are limitations to this approach because there is a lag between real-world price rises and policymakers having the retrospective data to make decisions about how to address problems with the economic outlook.

Changes to interest rates usually take around 18 months to have a tangible impact on demand because consumers may be in fixed-term deals or pricing contracts, which means an interest change does not immediately impact their financial circumstances.

The lag means that economists try to anticipate inflation trends before they happen by reviewing current rate levels and ongoing behaviours and signals in the major markets.

It is impossible to accurately identify inflation or how closely it will adhere to targets without statistics, which can also change suddenly due to abrupt shifts.

Central banks try not to anticipate inflation risks too early because reducing interest rates could be a major policy error. In contrast, unnecessarily high-interest rates could stifle crucial economic growth.

Monetary policy has as many limitations as CPI reporting because where there is low growth and inflation simultaneously, called cost-push inflation, this strategy may not apply.

Much also depends on confidence because businesses and households may spend higher amounts, regardless of interest rates, where they have confidence that their income or the wider economy will improve.

Other Inflation Controlling Strategies

Raising central bank interest rates higher and lower is one of several methodologies a government may apply to combat inflation rising too quickly or promote spending in a stagnating economy.

Fiscal policy

Fiscal policy means that the government changes taxes and spending levels to reduce the pressure of inflation. For example, they might increase taxes and reduce government spending.

The challenge can be political because higher taxes and government expenditure cuts have a limited lifespan and may be unpopular.

Exchange rate policies

The UK joined the Exchange Rate Mechanism (ERM) in the late 90s to try and control inflation by keeping the value of sterling high.

Theoretically, a stronger currency makes it cheaper to import goods, reduces domestic demand, and incentivises businesses to reduce their charges to become more competitive.

This approach was successful but was also a cause of the recession, whereby the government increased baseline interest rates to 15 per cent to retain the value of GBP.

Supply-side policies

A supply-side policy intends to boost productivity through practises such as privatisation to make industries more competitive. Deregulation is also thought to reduce the pressure of inflation.

The issue is that these approaches are long-term and cannot address sudden inflationary peaks.

Interest Rates And Cooling Inflation FAQ

Why do interest rates affect inflation?

Rising interest rates help to prevent excessive inflation, whereas lower interest means that inflation picks up speed.

Consumers tend to spend less when interest rates are higher and more when they are lower because financing costs less, and goods and services become cheaper.

What is the difference between inflation and interest?

Interest represents the percentage amount charged on borrowing or the amount earned on savings. Inflation reflects the rate at which prices increase for various goods and services.

Therefore, interest can be low even if inflation is high, whereby goods are becoming more expensive to buy, but it remains cheap to borrow.

This contrast is why central banks try to adjust interest rates to anticipate problematic inflation levels, whether positive or negative.

How long do interest rates take to affect inflation?

It is hard to give precise timescales because multiple factors influence inflation, with interest rates simply one tool that governments can use to try and address economic imbalances.

Most changes to interest rates are made gradually and can take several months to have a quantifiable impact on real-time inflation.

Is inflation a good thing for savers?

Normally, even if interest rates are climbing, it is expected that inflation at a level that prompts government intervention will increase much faster than interest.

For savers to profit from their deposits, the interest rate applied to their savings needs to outpace inflation, which is rare.

Inflation can be equally harmful to savers and borrowers, with higher interest rates making it more expensive to buy everyday items and borrow. However, it is equally unlikely to reach a point where they overtake inflation.

Does high inflation indicate a recession?

Inflation is not necessarily an indicator of recession, although higher interest rates can be a factor. A recession means a decrease in economic activity and that GDP falls for two quarters in a row.

In contrast, inflation means that the prices of goods and services have risen for a specific period in the economy.

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