How Interest Rates are Used to Beat Inflation

Pinoy Money Talk

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.

Pinoy Money Talk is an educational website about money, banking, investments, and personal finance which started in 2005. Its group of five writers consists of one equity research analyst, one fintech startup owner, one finance educator, and two investment professionals.