How interest rates influence inflation and growth

Understanding the basics

Imagine the economic interplay of interest rates and inflation as a sophisticated dance of supply and demand, set on the grand stage of the global economy.

Ideally, in this dance, supply waltzes in perfect time with demand, achieving a graceful market equilibrium.

However, reality often introduces an unexpected beat, much like the frenzy that erupts with the release of the latest iPhone or a groundbreaking AI innovation.
When demand energetically outpaces supply, prices whirl upwards until a new rhythm of balance is established.

The same concept can be applied to the money supply in an economy which is controlled by a country's central (reserve) bank.

Related article: Central bank intervention: monetary policy explained

The relationship between inflation and interest rates

There is a well-established relationship between interest rates and inflation. When inflation is high, central banks tend to raise interest rates to reduce consumer spending and investment, which can help slow down inflation.

Conversely, when inflation is low, central banks may lower interest rates to stimulate spending and investment, thus increasing inflation.

Interest rates, inflation and the economic cycle

During periods of economic expansion, where growth is robust, wages will often increase, promoting consumer spending.

This increase in demand can lead to inflation – a scenario where too much money is chasing too few goods.

To prevent the economy from overheating, central banks step in like a prudent overseer, raising interest rates in an effort to reduce the demand for money.
This move makes borrowing more expensive, gently tapping the brakes on spending.

In the aftermath of the Covid-19 pandemic, the large fiscal stimulus packages (released throughout 2020 & 2021) and supply constraints resulted in a higher demand for goods and an increase in consumer spending.

Consumer spending prior to the pandemic vs spending during the Covid-19 period

As the economy rebounded at a rapid pace, inflation surged.

To tame the elevated levels of inflation, many central banks began hiking interest rates at an aggressive pace, allowing price pressures to gradually ease.

Global inflation levels for 2020 - 2024

Source: Worldbank

With interest rates currently at decade highs, global economic growth has been shrinking, raising expectations that major central banks (Federal Reserve, European Central Bank and the Bank of England) may begin implementing rate cuts in the second half of this year (2024).

Interest rate expectations for the Fed and ECB in 2024

Source: Worldbank

During contraction: Contrastingly, in the quieter times of recession, a different strategy unfolds. Lowering interest rates acts like a beacon, inviting borrowing and investment. Businesses, enticed by cheaper loans, invest in growth initiatives, which in turn fosters employment and gradually rejuvenates the economy.

The dual mandate of central banks

To understand why this relationship is so critical, one must first understand the objectives of monetary policy.

Central banks juggle a dual mandate: keeping a rein on inflation and maintaining exchange rate stability. But their most pivotal role? Acting as a regulator on the economy's pace.

• Inflation management: When inflation dances beyond the target, typically around 2% for most major central banks, the response is often to tighten the monetary reins by increasing the central bank rate.
  
  This strategy aims to cool down an overheated economy and check rising prices.
• Exchange rate stability: While not always the star of the show, maintaining a stable exchange rate is vital, particularly for countries deeply engaged in international trade.
  
  A stable currency ensures a consistent tempo in international transactions.

These objectives, often intertwined, mean that actions in one arena can resonate significantly in the other.

Conclusion

Grasping this relationship is essential, not just for policymakers but for anyone navigating the economic currents of our world.

As we continue to witness rapid technological advancements and market shifts, this understanding becomes increasingly crucial. In the vast narrative of economics, just as consumers adapt to the latest iPhone, economies respond to the ebb and flow of interest rates and inflation, perpetually seeking harmony in a dynamic financial landscape.

Disclaimer: past performance does not indicate future results. The above content is to serve educational purposes and is not to be construed as investment advice.