How Interest Rates are Used to Beat Inflation

Whenever news regarding inflation is announced, expect succeeding reports to deal with interest rates.

For example, in the Philippines, news of rising inflation rate is usually accompanied by a note that the Bangko Sentral ng Pilipinas (Central Bank) will “raise key interest rates”.

Let’s analyze how the two are related and how they ultimately affect us consumers.

What is Inflation?

Inflation is the percentage change in overall prices between two periods as measured by a price index. For instance, an inflation rate of 9.6% means that, in simple terms, a product costing P100.00 last year is now selling at P109.60 this year — a 9.6% increase in prices from the previous period.

Simply speaking, you would need to spend P109.60 today to buy the same product which cost P100.00 last year.

A higher inflation undermines the purchasing power of a currency. This is because one needs more money at present compared to the previous period to buy the exact same thing.

So if inflation is rising and, given constant wages and personal incomes, consumers surely will feel the crunch.

What are Interest Rates?

Interest rates usually cited in Central Bank announcements typically refer to the benchmark rates — such as the federal funds rate of the US Federal Reserve used to control money supply. By imposing higher rates, the Central Bank effectively limits the ability of banks to lend money to customers.

How is this done and how does this affect customers? The impact of an interest rate hike is evident in these two (2) scenarios.

  1. Higher benchmark rates imposed by the Central Bank force banks to increase the interest rates on loans they charge to customers. This may be in the form of interest on a housing, car, or credit card loan.

If, for example, you were thinking of getting 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.

2. Banks may also choose to raise the interest on deposit accounts. With higher deposit interest rates, people might think twice about spending and simply decide to 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 will only be able to buy fewer products compared to before. As a consequence, demand for products is expected to decline.

When supply of that product exceeds demand, sellers will typically decide to lower their prices in order to sell. When prices are lowered, inflation — the change in prices from one period to another — goes down too.

So there, by imposing higher interest rates, the Bangko Sentral tries to reduce inflation. That’s what the Bangko Sentral ng Pilipinas plans to happen whenever it raises interest rates.

What are the drawbacks of higher interest rates?

It should be obvious by now.

Using our bank loan example again, you’d see that due to higher rates, business activity in the market may slow down. The threat of high interest rates can make individuals and companies rethink about taking out new loans which could have been used to finance a new business or to 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.

Thus, the Central Bank has to manage that delicate balance between interest rates and inflation; otherwise, a wrong move can cause massive economic impact.

16 thoughts on “How Interest Rates are Used to Beat Inflation”

  1. Nice article!

    Inflation really is a big pain in the a$$… Let’s hope the high interest rates would not scare away our Pinoys who want to start a business… We need more entreps with business ideas to flood the market so the prices of commodities would go down… tsk tsk tsk…. I wonder how this would impact pinoys involved with real estate, now that they have to pay more interest…

  2. How could central bank control inflation by raising interest rates? Inflation rises due to high food and fuel prices and not demand related. Would people stop buying food and fuel due to high interest rate? Sometimes common sense is not very common.

    1. @dannyph it can be demand related, production cost related , govt debt related, or forex related. In general, raising interest rates help temper consumer spending, which may slow down inflation by creating less demand. Yes of course people will continue to buy food and fuel. But there are too many complex factors surrounding inflation, not just consumer spending. Control what you can. Find more ways to create more income. Spend less and save more.

  3. What a crap decision by Central Bank. Rise in inflation is due to high food and fuel prices and not demand related. Will the people stop buying food and fuel due to high interest rates? Common sense in not very common even to decision makers.

  4. This is a very complicated Concept and the interrelatedness of the global market make this even more difficult to understand and predict. World economics is as unpredictable as the weather. There are general theories and concepts, but at the end of the day its impossible to predict what is going to happen.

  5. I’ve asking that question (what is inflation rate? what does it do?) to my self 😀 Thanks for the info.

  6. Philippines is facing a stagnating economy and a rising inflation which most call it stagflation. We can’t control inflation due to world rising oil and food prices but we can control the declining economy by lowering interest rates(i suppose) but what the monetary board is doing? Do they have hidden agenda or being dictated by world body.

  7. Very informative, thanks. I also find each of the above comments interesting. I guess this proves that we could have strong arguments both ways.

  8. in your view, are the banks right in imposing higher interest rates? what can be done to improve our economy given the current situation we are in now? i want to understand more. thanks for posting this informative entry.

  9. The BSP’s mission is to keep inflation between 3-5% (or some similarly low number), thus it really has to raise interest rates.

    Lowering peso interest rates tend to cause the peso to depreciate and make our imports even more expensive. If the BSP lowered rates and threw money around it would really worsen inflation. The BSP is doing the right thing and their moves will tend to strengthen the peso. Also, the current high interest regime helps savers weather inflation.

    One reason oil and commodities are so expensive is because the USD interest rate is pretty low right now. Thus, the increasing USD money supply means that goods priced in USD (oil) will tend to become more expensive.

    If you keep expanding the money supply (via low interest rates) with no increase in productivity, prices will just keep shooting up.

  10. In the 70s, thanks to the easy monetary policy promoted by Fed chairman Arthur Burns, the US experienced really bad stagflation. When Paul Volcker took over the Fed during Reagan’s time, he raised rates and was eventually able to kill inflation. Rates had to go up to 20% and the US economy suffered a painful recession before inflation returned to single digit levels.

    I would say this experience counts as good empirical evidence that high interest rates can combat inflation. On the flip side, the current high price in oil and other commodities could be seen as the result of the Fed keeping USD interest rates pretty low.

  11. thanks for the explanation.. given the current situation. where is it better to invest, in a 5-year time deposit with a 6.5% annual interest rate? or in a mutual fund? Thanks again in advance.

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