What is the relationship between inflation and interest rates?
Since the Reserve Bank of India (RBI), the central bank of India, primarily uses interest rates to moderate inflation, the two tend to move in tandem.
RBI has set a target for itself – to keep inflation low and in turn, increase the repo rates. Both high deflation—a protracted price decrease of goods and services—and inflation—a continuous rise in the overall price level for goods and services—can be detrimental to the economy. The central bank aims to keep the inflation rate stable.
A positive relationship between inflation and interest rates gives the central bank room to cut rates in the event of an economic slump. Let’s understand this relationship in a bit more detail in the rest of the article.
What is inflation?
Inflation is essentially the overall increase in prices for goods and services as well as the decrease in people's purchasing power.
To make it easier for you to relate, let's discuss food. Most of us enjoy eating burgers, but did you the Aloo Tikki Burger used to cost Rs. 20? Now, you can’t buy it for less than Rs. 45.
Consider having Rs. 100 in 2004. You could get five of these burgers. Today, you can only buy 2 of these burgers for the same Rs. 100! In other words, your purchasing power has significantly decreased. Why? Blame inflation.
The rate at which prices across the board are increasing and rising continuously is known as inflation. When prices rise, the buying power of a currency decreases; your buying power decreases. The inflation rate must be within acceptable parameters for an economy to run smoothly.
What are interest rates?
Interest is calculated on the amount borrowed from the lender. Interest rates significantly affect the economy, stock prices, and other forms of investment. A combination of the following two variables determines interest rates:
It is expensive to borrow money if interest rates are high.
Customers will be less likely to maintain their money in the bank if they do not receive a satisfactory return on their investment. Therefore, the bank will be short on cash.
If money is inexpensive, cash in the market will rise, which will eventually lower its value. As a result, prices will rise faster than usual.
Deposits earn a lower interest rate than loans. Deposit rates are lower than loan rates, while loan rates are much higher. Simply put, the interest rate is the cost associated with either depositing or borrowing funds.
Relationship between Inflation and Interest Rates:
Here is the inflation and interest rates relationship:
Quantity Inflation is, according to the Theory of Money, a function of the supply and demand for currency. When the money supply grows, inflation does too; conversely, when it shrinks, inflation falls. The correlation between inflation and interest rates is investigated using this theory. Inflation falls when the interest rate is high because there is less money in circulation. In contrast, when interest rates are kept artificially low, the money supply expands along with inflation, and the economy experiences a surge in demand.
When inflation is high, the central banks raise interest rates to bring it under control. Increases in interest rates make borrowing money more expensive. It raises the cost of borrowing money. As a result, people will be less inclined to take out loans, reducing the money supply. Reduced purchasing power means fewer lavish purchases as the market's money supply shrinks. Goods and services become less expensive when demand falls, and supply stays the same.
A lower interest rate is implemented in cases where inflation is low. Lower interest rates encourage people to take more loans, which increases the money supply in the economy. There will be more money available for purchases as the money supply increases. As a result, inflation will occur as the price level rises in response to increased demand for goods and services and a constant supply.
Interest rates and money supply are inversely related each other. As explained above, inflation and market money circulation are both reduced when interest rates are high. In contrast, a higher inflation rate is associated with a lower interest rate since a lower rate leads to more excellent market money circulation.
How does the RBI control inflation?
To clarify, let's consider the year 2020. The country was put on lockdown because of the coronavirus. The stoppage in economic activity led to a shortage of currency. However, RBI rescued the economy.
First, the RBI conducted open market operations totaling Rs. 1,24,154 crores to increase market liquidity. RBI's ability to manage the currency supply is achieved through open market operations, which involve purchasing and selling government securities (G-Secs). By buying G-Secs, the Reserve Bank of India (RBI) injects funds into the market and drains them out of the economy.
The Reserve Bank of India increased the repo rate by 40 basis points in May 2022. The repo rate has increased from 4% to 4.40%, marking a new high not seen since 2000. Repo rate is the rate at which banks borrow money from RBI. Reverse repo rate is the rate at which RBI borrows money from the banks.
By raising repo rates, RBI discourages banks from borrowing (and lending to individuals). And by raising reverse repo rates, RBI encourages banks to deposit more money with it, reducing the money supply. Spending decreases, demand drops, and prices fall as a result.
You realise that the impact of interest rate cuts and raises on inflation is clear, right? That's how the RBI keeps an eye on interest rates and by extension, on inflation.
Because policymakers need information about past inflation trends to make predictions, and because interest rates set by policymakers take time to affect the economy, interest rates and inflation tend to move in the same direction but with lags. However, slower economic growth often results in lower inflation, which might lead to rate decreases if inflation continues to rise.
Q. To what extent do varying interest rates curb inflation?
There is a negative relationship between interest rates and price increases. People borrow more from banks and put less money away because of low-interest rates. Both the money supply and the demand in the economy benefit from this. This leads to inflation as commodity prices increase.
Q. Do interest rates and inflation fluctuate together?
Since the Reserve Bank of India uses interest rates to moderate inflation, the two tend to move in the same direction.
Q. Why does a rise in interest rates halt inflation?
Some believe that if interest rates on loans and credit card balances rise, customers will borrow less and cut back on their spending. This decreases the money supply in the economy. Without money to spend, the demand for commodities decreases, which puts a dampener on price rise, thus controlling inflation.
Arbitrage is a type of trading in which a trader tries to make money from the difference in the prices of similar financial instruments, typically listed on different trading platforms.