The Relationship Between Inflation and Interest Rates

If you’ve had your finger on the pulse of the finance industry recently, you’ve probably heard frequently about rising inflation and interest rates. While investors and economists are fluent in finance lingo, these terms can confuse everyday Australians. To most of us, high inflation and interest rates simply mean our day-to-day living is becoming more expensive.

However, inflation and interest rates serve very different purposes. Inflation measures a change in the cost of goods and services, while interest rates exist as a countermeasure to help reduce inflation.

What is Inflation?

Inflation is a measurement used to track the rising cost of goods and services in a country. For example, you purchased a litre of milk for $1.55. Today, you go to the store and buy a litre of milk from the same brand for $1.60. Inflation for that milk would be 3.2%.

When inflation is high, it typically means people are paying more for their everyday goods and services, and regulatory bodies take notice. When prices are down, this is called deflation.

What is Interest?

While inflation extends to all purchases, interest is applied to debts and savings. If you open a bank account with a deposit of $40,000 at 5% interest per annum, you will earn $2000 in interest over the year.

On the other hand, if you have a home loan at 5% interest and your monthly principal repayment is $3,000, you will pay $150 in interest per month.

Rising interest rates are typically signs of high inflation, as interest is an effective way to combat inflation. Higher interest rates affect how much people looking for loans can borrow, reducing the activity in the market. This means fewer people borrow less money, and the economy can stabilise.

With interest rates remaining high, the hope is that inflation will begin to reduce. For reference, The Reserve Bank of Australia (RBA) raised its cash rate in November 2023; inflation was at 5%. A higher cash rate typically means higher interest rates from the banks.

While consumer spending is a key driver of inflation, it’s not the only one. Environmental factors regularly affect significant shifts in inflation. The COVID-19 pandemic greatly impacted the economy, and some experts equate today’s inflation to high government spending during the pandemic and high consumer spending as lockdowns ended.

Inflation is currently declining, and the cash rate is anticipated to follow suit, possibly early next year. However, we can’t say for certain. Inflation could always go back up, meaning high interest rates need to be implemented for a while longer.

If you have any questions regarding inflation or interest rates or just want to discuss your financial goals, reach out! I’m always keen for a chat.

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