Demystifying Inflation & the Interest Rate

Simply put, Interest Rates describe the cost of borrowing money. However there are a number of factors that influence the perpetual rise and fall of Interest Rates. The Inflation rate is one such factor.

Inflation may be described as the change in the price of "goods and services" over a period of time. As inflation goes up, the purchasing power of consumers goes down. To compensate a drop in purchasing power, wages must increase.

Unfortunately for the consumer, Inflation is incorporated into the pricing of the bank’s "goods and services". This means when a bank lends you a given amount of money today, they are aware the amount will be worth relatively less in one years time. With this in mind, the bank charges interest to compensate both for the profit it could’ve made investing that money and for the lost value of the money due to inflation.

So what has inflation got to do with Interest Rates? Well, when Inflation exceeds the rate at which wages increase and consumers are no longer able to pay for "goods and services", the Reserve Bank intervenes and increases Interest Rates. As a consequence of increasing Interest Rates, a greater proportion of the Economy is spent on repaying home loans, this reduces the overall demand for "goods and services" and in turn, prevents the cost of "goods and services" or Inflation from going up.

Thankfully for us, as the rate of inflation slows down, wages have an opportunity to catch up.

Happy Savings!

Dave Kaplan.