Inflation vs Interest Rates: How Does One Influence Another?

Market reactions to changes in interest rates can be both favorable and unfavorable. In reaction to economic activity, central banks frequently adjust their target interest rates, raising them when the economy is excessively robust and decreasing them when it is weak.

In today’s article, we want to bring the topic of how interest rates affect the inflation rate closer to you. You will learn:

  • What is inflation?
  • What are the kinds of inflation?
  • What are the interest rates?
  • Inflation vs interest rates – how are interest rates affected by inflation?
  • Become financially independent – the Infinite Banking Concept

Let’s start!

inflation vs. interest rate

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What is Inflation?

Price increases, or inflation, can be thought of as the gradual loss of purchasing power. Over time, the average price increase of a selection of products and services can serve as a proxy for the rate at which buying power declines. 

A unit of currency effectively buys less due to the increase in pricing, which is sometimes stated as a percentage. Deflation, which happens when prices fall and buying power rises, can be compared to inflation.

In simpler words, the objective of measuring inflation is to determine the overall effect of price changes for various goods and services. It enables a single value representation of the rise in the cost of goods and services over time in an economy.

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Inflation Example

If in 1990, a man spent INR 100 per day on gasoline for his car and the cost of one liter was INR 40, he would receive 2.5 liters of gasoline. He will receive 1.1 L of gasoline if he spends INR 100 on gasoline at the current rate of INR 90 a liter. Despite INR 100’s constant value, its purchasing power had declined 28 years earlier. Thus he could buy 2.5L of gasoline for the same price as 1.1L of gas now.

“Demand Pull” Inflation

In general, economies are anticipated to expand rather than stabilize or decelerate. Inflation can be brought on by an expanding economy, possibly resulting from low-interest rates, as people tend to spend more money in expanding economies. 

As sellers anticipate this demand, prices rise, leading to inflation. It’s called “demand-pull” inflation. 

The general price level may rise more if supply does not keep pace with the demand for goods. Consumers may buy items sooner if they anticipate future price increases to avoid paying more later, which helps the economy thrive.

Inflation results when the general demand for goods and services grows more quickly than the economy’s capacity to produce them. This happens when the quantity of money and credit increases. This drives up demand and raises prices. 

A positive consumer attitude results from people having more money. This then triggers increased spending, which raises prices. With increasing demand and a less adaptable supply, it causes a demand-supply mismatch and higher prices.

“Cost-Push” Inflation

The rise in prices affects the inputs used in the production process, which leads to cost-push inflation. Costs for all types of intermediate goods increase as more money and credit are directed toward the commodities or other asset markets. This is particularly clear whenever there is a bad economic shock that affects the supply of important commodities. 

These changes drive up the price of the final good or service, which in turn drives up consumer pricing. For instance, when the money supply is increased, oil prices experience a speculative rise. This implies that the price of energy may increase and affect consumer prices, which are reflected in various inflation indicators.

A rise in corporate expenses can also bring on inflation. Due to the basic laws of supply and demand, prices will increase if manufacturers reduce production while demand stays the same. A slowdown in manufacturing could be brought on by increased costs for exports, new taxes, or higher wages.

“Built-in” Inflation

Adaptive expectations, or the notion that individuals anticipate present inflation rates to persist in the future, are related to built-in inflation. People may anticipate how the fall in inflation will affect them or an ongoing increase at a similar rate as the price of products and services grows. 

Workers may therefore request higher costs or wages to maintain their standard of living. The cost of goods and services rises due to their increasing earnings, and this wage-price spiral keeps going as one element drives the other and vice versa.

How Is It Measured?

CPI

The Consumer Price Index (CPI) is a tool used by the U.S. Bureau of Labor Statistics (BLS) to calculate inflation and control high inflation. Information for the index is gathered from a survey of 23,000 firms. 

It keeps track of the pricing of 80,000 consumer goods every month. You can find out the general rate of inflation from the CPI. The CPI has been used by the BLS to display the inflation rate since 1990.

To control inflation, monetary policy is used by central banks around the globe to prevent inflation and deflation, which is its opponent. The Federal Reserve Bank in the US aspires for an inflation rate of 2% on an annual basis. 

On August 27, 2020, the FOMC stated that it would permit a target inflation rate of more than 2% if doing so would help to ensure maximum employment. It continues to aim for average inflation of 2% but is open to higher rates if inflation has been low for a while, as evidenced by the rate in October 2021.

PCE

Another method to maintain a healthy economy and control inflation is called Personal Consumption Expenditures Price Index (PCE). The Bureau of Labor Statistics (BLS) collects spending information from tens of thousands of typical customers across the U.S. to compute CPI inflation. 

It analyzes a selection of frequently purchased items and services, such as food, gas, computers, prescription medications, college tuition, and mortgage payments, to determine how a general price level evolves and is the supply remains constant.

Food and energy are two items that can experience very large price variations from one month to the next due to seasonal demand and probable supply interruptions domestically and internationally. Due to this, the BLS also releases Core CPI, a measure of underlying inflation that omits volatile food and energy costs on purpose.

What Are The Interest Rates?

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The amount a lender charges a borrower is an interest rate, expressed as a percentage of the principal or the loaned amount. A loan’s interest rate is typically defined as an annual percentage rate, or APR (APR). 

A savings account or certificate of deposit earnings at a bank or credit union may also be subject to an interest rate (CD). The interest received on these deposit accounts is measured in annual percentage yields (APY).

Simple Interest Rates

Simple interest is often a predetermined percentage of the principal amount borrowed, lent, paid, or received over a specific period. 

Compound Interest rates

Borrowers are required to pay interest on interest in addition to principal since compound interest accrues and is added to the accumulated interest from prior periods.

Inflation vs Interest Rates – How Does One Relate To Another?

In the event of the raising interest rates, there is less money available, which leads to lower inflation and, ultimately, a fall in supply. In contrast, when the interest rate is reduced or low, there will be a greater supply of money, which causes inflation to rise and, in turn, raises demand. In other words, inflation and interest rates affect one another.

The central bank raises interest rates to combat high inflation. The cost of borrowing grows as the interest rate does. It raises the cost of borrowing. Borrowing will thus decline, and the money supply will fall. 

If the market’s money supply declines, people will have less money to spend on pricey products and services. The demand for products and services will decline with a constant supply, which results in a fall in prices.

The rate of interest decreases when there is less inflation. A fall in interest rates will result in more affordable borrowing. As a result, both borrowing and the money supply will rise. As the money supply increases, people will have more money to spend on products and services. If supply remains constant, it will boost asset prices, and there will be a growth in demand for goods and services, known as inflation. 

The federal funds rate is the interest rate that affects the stock market. It is a target rate at which commercial banks borrow. 

The discount rate is the interest rate that Federal Reserve Banks charge when they make secured loans to depository institutions, typically overnight. In contrast, the federal funds rate is the interest rate that depository institutions—central banks, savings and loans, and credit unions—charge each other for overnight loans. 

To keep a healthy economy and rising inflation and interest rates under control, the Federal Reserve affects the federal funds rate. The Federal Reserve is effectively trying to reduce the amount of money available for making purchases by raising the federal funds rate. They have to follow inflation expectations to maintain purchasing power. 

Inverse Relationship Between Inflation and Interest Rates

relationship between inflation and interest rates

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In the event of rising interest rates, inflation falls. Higher interest rates bring inflation down. That leads to a decline in market circulation. Consumers spend less, and demand for goods and services falls. A rise in interest rates lowers the cost of goods and services. 

And as we said, it is an inverse relationship. High inflation means lower interest rates. The popularity of borrowing rises, and demand for goods is also rising because it makes borrowing cheaper the cost of products and services increases.

Higher inflation vs. your savings

According to the economic theory known as the Fisher Effect, inflation is correlated with the real and nominal interest rates. Nominal rates describe the amount a saver receives when they deposit money in a bank. 

In other words, even after adding the $20 earnings, your cash has lost some of its purchase value. This truly adds up in the long run. 

The most important thing to keep in mind is that real interest rates and nominal interest rates differ from one another and that inflation affects how they interact.

Become Financially Independent

Understanding how interest rates and inflation work is a first step to making more responsible financial decisions. 

However, sometimes borrowing money from a third party may come with higher interest rates, issues with taking out personal loans, instability in the stock market or bond markets, and other investments. That is why we want to encourage people to consider alternative investment decisions, like Infinite Banking. 

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The Infinite Banking

The Infinite Banking Concept sometimes referred to as overfunded life insurance, is a financial tactic that makes use of an overfunded whole life insurance policy by using the cash accumulation to increase and create wealth. 

Therefore, you must first purchase a whole life insurance policy, which is a remarkable method to begin the Infinite Banking process while also having a long-term insurance and investment tool. 

The whole life policy is used in the Infinite Banking Concept to make additional contributions to the policy that directly increase the cash value. 

This money can be accessible through withdrawing dividends from life insurance, policy loans, or cash withdrawals and accumulates tax-free interest in the policy’s cash account. You can apply borrowing or spending however you like and still save up.

The Advantages Of The Overfunded Life Insurance

Absolute liquidity or an increase in cash flow is the overfunded life insurance benefit that matters most. Because a loan can be obtained more rapidly, a whole life policy’s value is significantly more liquid than other financial assets.

The person can have cash in hand more quickly than they could from a regular bank and without paying any extra fees or interest. 

This explains why this tactic is often known as “becoming your own bank.” You are acting as your bank by borrowing money from your insurance and repaying it. 

Final Thoughts

We sincerely hope that this post has given you the knowledge you need to understand the relationship between inflation and interest rates. Overfunded life insurance is the best option if you do not want to borrow money from commercial banks.

You can use the Infinite Banking Concept to borrow the money you require without going via a traditional bank or adding to your debt load. 

At Wealth Nation, we’ll show you how to use your whole life insurance to independently manage, develop, use, and build your financial resources.