The interest rate, the cost of borrowing, is one of the main tools of monetary policy for central banks, and any change in interest rates impacts the macroeconomy indirectly, including inflation, employment rates, and economic growth; hence, its importance for investors. This blog will shed light on the impact of interest rates on the inflation rate.
Countries tend to adopt a tightening monetary policy, aka increase interest rate, to curb the persistent inflation rate to incentivize individuals to save their money at the bank rather than spend it, hence, reducing the money supply from the economy to eventually stabilize inflation to normal levels, driving interest rates to normal levels as well. An example of the positive relationship between the Fed Fund Rate and inflation is that they both relatively move in tandem, as seen in the below figure. Therefore, the real interest rate is a good indicator of the tightness of credit market conditions.
Source: Trading View (October 2023)
As global inflation figures rose in late 2021-2023, central banks around the globe decided to increase interest rates. For instance, the Bank of England (BOE) increased the interest rates 14 times in a row, an unprecedented pace in almost the past two decades. We also witnessed the Fed, in only a year and a half, raising interest rates 11 times, and the European Central Bank (ECB) raised interest rates 10 consecutive times, the most rapid rise in its history, and the list goes on.
On the other hand, there is a tough decision between raising interest rates and economic growth. At times of slow economic growth, central banks decrease interest rates on borrowing to encourage borrowing; thus, encouraging spending. Since the GDP is a summation of government and consumer spending, investments, and net exports, as one component increases, ceteris paribus, the GDP increases driving the wheel of the economy, achieving higher employment rates, and eventually economic growth.
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