Relation between inflation rates and interest rates

Question

In Canada, as of the time of writing this question, the:

• Key interest rate is 1.00% (source)
• The inflation rate is 1.50% (source)

In India, at the time of writing, the:

• Base interest rate is 8.00% (source)
• The inflation rate is 8.31% (source)

In order to at the very least have my savings stay in tune with inflation, I purchase a GIC (guaranteed investment certificate) in Canada that gives me an interest rate of 1.50%.

My research leads me to believe that the reason interest rates are low at this point in Canada is primarily due to the government trying to stimulate the economy and encourage borrowing.

Alright, let's say a couple years down the road, there is more economic activity and the Canadian government wants to curb easy borrowing. In order to curb easy loans and mortgages, the key interest rate rises from 1.00% to 2.00%.

Questions:

• Is it true that due the to the increase in interest rates that inflation is likely to increase as well?
• Under what condition does the interest rate ever go higher than the inflation rate? In both examples (Canada and India), inflation is higher than interest.

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I am a risk averse investor looking for moderate growth with my savings through not so complicated investment vehicles.

Answer 1

Possibly but not necessarily, though that can happen if one looks at the US interest rates in the late 1970s which did end with really high rates in the early 1980s.

Generally interest rates are raised when inflation picks up as a way to bring down inflation.

Answer 2

When the inflation rate increases, this tends to push up interest rates because of supply and demand: If the interest rate is less than the inflation rate, then putting your money in the bank means that you are losing value every day that it is there. So there's an incentive to withdraw your money and spend it now. If, say, I'm planning to buy a car, and my savings are declining in real value, then if I buy a car today I can get a better car than if I wait until tomorrow. When interest rates are high compared to inflation, the reverse is true. My savings are increasing in value, so the longer I leave my money in the bank the more it's worth. If I wait until tomorrow to buy a car I can get a better car than I would be able to buy today. Also, people find alternative places to keep their savings. If a savings account will result in me losing value every day my money is there, then maybe I'll put the money in the stock market or buy gold or whatever.

So for the banks to continue to get enough money to make loans, they have to increase the interest rates they pay to lure customers back to the bank.

There is no reason per se for rising interest rates to consumers to directly cause an increase in the inflation rate. Inflation is caused by the money supply growing faster than the amount of goods and services produced. Interest rates are a cost. If interest rates go up, people will borrow less money and spend it on other things, but that has no direct effect on the total money supply.

Except ... you may note I put a bunch of qualifiers in that paragraph. In the United States, the Federal Reserve loans money to banks. It creates this money out of thin air. So when the interest that the Federal Reserve charges to the banks is low, the banks will borrow more from the Feds. As this money is created on the spot, this adds to the money supply, and thus contributes to inflation.

So if interest rates to consumers are low, this encourages people to borrow more money from the banks, which encourages the banks to borrow more from the Feds, which increases the money supply, which increases inflation.

I don't know much about how it works in other countries, but I think it's similar in most nations.

Answer 3

I haven't read the terms here but the question may not have a good answer. That won't stop me from trying.

Call the real rate (interest rate - inflation) and you'll have what is called negative real rates.

It's rare for the overnight real rate to be negative. If you check the same sources for historical data you'll find it's usually higher. This is because borrowing money is usually done to gain an economic benefit, ie. make a profit. That is no longer a consideration when borrowing money short term and is IMO a serious problem. This will cause poor investment decisions like you see in housing.

Notice I said overnight rate. That is the only rate set by the BoC and the longer rates are set by the market. The central bank has some influence because a longer term is just a series of shorter terms but if you looked up the rate on long Canadian real return bonds, you'd see them with a real rate around 1%.

What happens when the central bank raise or lowers rates will depend on the circumstances. The rate in India is so high because they are using it to defend the rupee. If people earn more interest they have a preference to buy that currency rather than others. However these people aren't stupid, they realize it's the real rate that matters. That's why Japan can get away with very low rates and still have demand for the currency - they have, or had, deflation. When that changed, the preference for their currency changed.

So if Canada hast forex driven inflation then the BoC will have to raise rates to defend the dollar for the purpose of lowering inflation from imports. Whether it works or not is another story. Note that the Canadian dollar is very dependant on the total dollar value of net oil exports.

If Canada has inflation due too an accelerating economy this implies that there are profitable opportunities so businesses and individuals will be more likely to pay a positive real rate of interest. In that scenario the demand for credit money will drive the real rate of return.

Answer 4

Is it true that due the to the increase in interest rates that inflation is likely to increase as well?

It is typically the reverse where inflation causes interest rates to rise.

Interest rates fundamentally reflect the desire for people to purchase future goods over present day goods. If I loan money to someone for 5 years I lose the ability to use that money. In order to entice me to loan the money the borrower would have to offer me an incentive, that is, they would have to give me additional money at the end of that 5 years. This additional money is the interest rate and it reflects the desire of people to spend money in the future versus the present day. If offered the same amount of money today versus 5 years from now almost everyone would chose to take the money now. Money in the present is more valuable than the same amount of money in the future.

Interest rates would still exist even with a currency that could not be printed. I would still prefer to have the currency today than in the future.

If the currency is continually devalued (i.e. the issuer is printing more of the currency) than borrowers may charge additional interest to compensate for the loss in purchasing power when they make a loan.

Also, it is hard to compare interest rates and inflation. Inflation is very difficult to calculate. New products and services, as well as ever changing consumer desires, continually change the mixture of goods in the market so it is nearly impossible to compare a basket of goods today to a basket of goods 5, 10, 20, or 30 years ago.