How are Inflation & Interest Rates Related?

Any ‘chai pe charcha’ is usually incomplete without discussing how pricey goods are becoming day-by-day, or without listening to parents rant about how inexpensive lifestyle used to be when they were kids. Well, this is the tragic magic of inflation, fellas!

But you know what, to an extent, this inflation is actually under the control of the central bank, in our case the RBI. How is that, you ask? Well, Interest rates. 

Confused? 

If you aren’t aware, here’s your help guide to the relationship between Inflation & Interest rates.

So, wait for what? Hop in.

What is Inflation?

Inflation is basically the general rise in the price of goods and services and the decline in purchasing power of people. This means that when inflation rises (without an equivalent rise in your income), you are able to buy lesser things than you could buy previously, or you have to pay more money for the same stuff now.

Let’s talk in terms of food so that you can relate well. Most of us love eating burgers at McDonald’s. But do you know, the people’s favourite McAloo Tikki Burger, which was sold for Rs.20 when it was launched in India in 2004, costs Rs.45 now! Say you had Rs.100 in 2004. You could fetch 5 such burgers. With the same Rs.100 today, you can get only 2 such burgers! Meaning, your purchasing power has reduced drastically. The obvious reason - Inflation.

To know more about Inflation, you can read one of our previous blogs here.

What are Interest Rates?

Interest rate is basically a percentage of the principal (the amount you are borrowing) that the lender charges from the borrower for the money lent. Not just that, it’s also a fraction of deposits that a depositor gets from an institution (bank or otherwise). So, from savings bank interest to interest on loans, these rates are very crucial for the economy.

Interest rates play a vital role in the economic development of a country, they significantly influence the stock prices and other investment decisions.

Relationship between Inflation and Interest Rates

Inflation is determined by supply and demand for money according to the Quantity Theory of Money (economic theory defining the relationship between money supply and price of a product). Money supply and inflation are directly proportional to each other. In simpler words, it means rising money supply in the economy triggers the inflation to rise and declining money supply in the economy leads to a decrease in inflation. Let’s understand how this defines the relationship between inflation and interest rates.

When the employment rate declines in the phase of recession (cause could be anything), it triggers falling income of people and so their spending. Less spending = less demand. The Law of demand says, less demand = less price. Lesser price = Fall in inflation. 

When the inflation rate fluctuates, the central bank (RBI in India) enters into the picture and makes changes in the interest rates to control the inflation. I’m sure that one question must be revolving in your head now…"HOW?"

During falling inflation, RBI lowers the interest rates. So, people get less interest on their deposits and are motivated to spend more than saving. Plus, lower interest rates incentivises people to borrow more by paying less interest. All in all, it triggers consumer spending, and thus, the demand.

So, now you got the answer? More spending by retailers and more borrowings by businesses increases the money supply in the economy. So this increasing money supply in the economy will trigger inflation to rise and thus, the problem of lower demand will be solved.

Further, as inflation rises much higher because of high demand, RBI will again step up and will increase the interest rates. When interest rates will increase, people will save more as they will be getting higher interest on their deposits and businesses will cut their borrowings as the cost of funding will rise for them. This, ultimately, will result in decreasing money supply in the economy. Again, by the Quantity theory of money, inflation will fall and the problem of higher inflation will be resolved.

How Exactly does the RBI Control Inflation?

Let’s look at 2020 to understand this better. A tiny virus shut an entire nation! Yes, we’re talking about the Covid-19 pandemic. All business operations were halted and thus money supply was in a crunch. Meanwhile, RBI flew in like an angel to save the economy.

Firstly, RBI injected the market with Rs. 1,24,154 crores via open market operations to infuse liquidity in the markets. Open market operations refer to buying and selling of government securities (G-Secs) by RBI to control the money supply. RBI infuses liquidity in the market by buying G-Secs and pulls out the money from the economy by selling G-Secs.

Last year on 22nd May 2020, RBI cut the repo rate by 40 basis points. Repo rate fell to 4% from 4.40% earlier, lowest since 2000. If you aren't aware, Repo rate is the rate at which RBI lends money to commercial banks, whereas reverse repo rate is the rate at which RBI borrows from commercial banks.

It’s obvious that by increasing repo rates, RBI tries to reduce the money supply by discouraging banks to borrow (and lend money to people), whereas by increasing the reverse repo rates, RBI incentivises the banks to deposit more money with it, thus cutting down the supply of money. As a result, consumer spending falls, demand falls and thus, the prices.

So, now you know how the interest rate cuts & hikes influence inflation, right? That’s basically how the RBI controls the interest rates and thus, to some extent, inflation.

The Bottom Line

Interest rates drive inflation in the opposite direction. Higher interest rates reduce inflation whereas lower interest rates lead to a rise in inflation. The right amount of inflation is good for the economy. RBI controls the interest rates via monetary policy using various measures such as reducing or increasing policy rates, conducting open market operations, etc.

Always remember, that higher interest rates are a blessing for savings-oriented people and a curse for people willing to borrow, and the reverse is true for lower interest rates.

So, inflation is an upward-sloping curve. There is no reason to believe that it's’ under anyone’s control. What can be done though, is trying to beat inflation with some intelligent investment strategies. So, if you wanna know how to beat inflation, here’s a blog.

Happy Investing!