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What effect does inflation have on interest rates?

14 Sep 2022 0 COMMENT

Introduction

In simple terms, the price rise in everyday goods and services is known as inflation. Inflation decreases the purchasing power of money as it buys lesser goods that it could buy earlier. The rate at which the prices of goods and services rise is called the inflation rate.

Whereas, the interest rate is the price of borrowing money from the banks or the returns on savings.

How is inflation measured?

Inflation in the country is measured with the help of the Wholesale Price Index (WPI) and Consumer Price Index (CPI). In WPI, prices are quoted from the wholesalers while in CPI, the prices are quoted from the retailers. The WPI was used to measure inflation up to April 2014. Now the RBI uses CPI (combined) to measure inflation rates in the economy.

The relationship between interest rates and inflation

Interest rates and inflation are inversely proportional. Low interest rates lead to people borrowing more from banks and saving less. This increases the supply of money in the economy and also the demand. As a result, prices of the commodities rise and cause inflation. In this scenario, the RBI tends to increase the interest rates to reduce the money supply. People, on the other hand, tend to borrow less and save more when interest rates are high. The result is a decline in money supply and demand for goods and services as well as a decrease in price. In this situation, the central bank decreases the interest rates through its monetary policies. This way, RBI tries to balance the money supply and interest rate to create a conducive environment for economic growth. The monetary policy of RBI refers to the management of interest rates, money supply, and credit availability to enhance growth in the economy.

The Finance Act, 2016, amended the Reserve Bank of India Act, 1934, to provide statutory status to the Monetary Policy Committee. The committee is entrusted with the management of benchmark policy rates or repo rates to maintain the inflation level in the economy while keeping growth objectives in mind.

The RBI manages interest rates through the following monetary policy tools:

  • Bank rate: It is the interest rate at which the central bank lends to the commercial banks. When there is inflation, the RBI increases the bank rate to reduce the money supply in the economy. By doing this, the central bank ensures the commercial banks create less credit leading to reduce money supply. With less money, there is lesser demand and hence prices fall.
  • Open Market Operation (OMO): The purchase and sale of government securities by the RBI are known as OMO. During inflation, RBI sells government securities to suck out excess liquidity from the market. The buyer of the securities pays in the rupee which leads to less money supply in the economy.
  • Cash Reserve Ratio: The proportion of deposits that the banks are required to keep with the central bank in cash is called the Cash Reserve Ratio (CRR). So, if the central bank increases CRR, banks will have to keep more money that cannot be lent. As a result, the money supply will reduce causing inflation to come down.
  • Statutory Liquidity Ratio: Statutory Liquidity Ratio (SLR) is the percentage of deposits that the banks are required to keep in the form of liquid government securities or other approved securities. An increase in SLR means fewer funds to lend and reduced money supply.
  • Repo and reverse repo rates: The rate at which RBI lends to the banks is called the repo rate and the rate at which banks park their surplus money with the RBI is called the reverse repo rate. Repo and reverse repo rates come under the Liquidity Adjustment Facility tool and use to control the money supply. An increase in repo rate increases borrowing cost, thus reducing the money supply and helping control inflation.
  • Marginal Standing Facility: Marginal Standing Facility (MSF) is a penal rate at which banks borrow from RBI over and above the LAF. It helps manage volatility in overnight interest rates in inter-bank lending. This monetary policy tool also has an indirect impact on the interest rates and money supply in the economy.

What does it mean to the savings?

When interest rates fall, saving becomes less attractive with low returns. Thus, people prefer to spend. On the other hand, when interest rate rise, saving becomes more attractive with higher interest rates on the deposits and people prefer to spend less and save more. So, higher interest rates are a boon for the saving-oriented people and a bane for the people who wish to borrow and vice-versa.

Conclusion

So, this is how interest rates and inflation are interconnected. High-interest rates help in reducing inflation while low-interest rates may lead to a rise in inflation. It is to be noted that some amount of inflation is actually good for the economy.

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