Relationship between interest rates and inflation

Two major economic news were announced this week. First, the inflation rate of the Philippines is now said to be at a 9-year high of 9.6% and, to address this, the Bangko Sentral ng Pilipinas (Central Bank) decided to raise key interest rates by 25 basis points.

Let’s analyze each issue and see how they are related to each other and how they affect us.

What is inflation?

Inflation is the percentage change in overall prices between two periods as measured by a price index. The country’s 9.6% inflation rate means that, in simple terms, a product costing P100 last year is now selling at P109.60 this year.

A higher inflation undermines the purchasing power of a currency. This is because one needs more money today compared to last year to buy the exact same thing. So if inflation is rising and wages and personal incomes are not, consumers will surely feel the crunch.

What are interest rates?

In the context of inflation, interest rates refer to the benchmark rates such as federal funds rate that the Central Bank (Federal Reserve in the US) uses to control money supply. By imposing higher rates, the Central Bank effectively curtails the ability of banks to lend money to their customers.

How? The higher benchmark rates forces banks to increase their own interest rate charged to customers. These may be interest charged on one’s housing, car, or credit card loans. If, for example, you were thinking of taking out a bank loan to be able to buy a house, you might back out if you discovered that the interest rate on housing loans has increased. In this case, the money that should have been loaned to you is retained with the bank and does not flow to the market.

Banks may also choose to raise the interest on deposit accounts. With higher deposit interest rates, people might think twice about spending  and decide to simply save. By saving, the supply of money in the market becomes limited.

How are inflation and interest rates related?

With less money to spend and weaker purchasing power, people can buy fewer products compared to before. As a consequence, demand for products declines. When supply exceeds demand, sellers will opt to lower their prices in order to sell their products. When prices are lowered, inflation rate goes down too.

So there, by imposing higher interest rates, the Bangko Sentral can control inflation. We can thus say that there’s an inverse relationship between interest rates and inflation.

With higher interest rates, a Central Bank expects to reduce inflation. That’s what the Bangko Sentral ng Pilipinas expects to happen when it raised the interest rate yesterday by a quarter of a percentage point (25 basis points).

What are the drawbacks of higher interest rates?

It must be pretty obvious by now. Using again our bank loan example, you’d see that due to higher rates, business activity in the market slows down. The threat of high interest rates makes individuals and companies defer taking out loans which could have been used to finance a new business or build a house. Less economic activity translates to slower economic growth. Slower growth means reduced company investments, less job opportunities for people, or worse, lay-offs of employees.

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