Inflation vs Interest rate
The economic standing of a country is measured using different economic indicators. A country must be aware of how it is performing so that its citizens, as well as businesses, are provided with optimum working and living conditions.
There are many indicators used in measuring the strength of an economy. However, there are two that are very popular owing to the effect that they have at any given time; inflation rates and interest rates.
This article will discuss the relationship between inflation and interest rates. It will also touch on how these two indicators affect forex trading.
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What is Inflation Rates?
We need to start by understanding what inflation means.
In economics, inflation is explained as the measure of how fast or slow the prices of goods and services are increasing within a specific period.
Inflation is the reason our parents bought movie tickets for less than a buck, yet we have to pay about $10 for the same.
When the inflation rate is high, it is because the prices of goods and services are also increasing at a steady pace. Conversely, when the inflation rate is low, the increase in the prices is still happening, but at a slow pace.
The inflation rate is a tricky concept in that it should be kept at optimum levels. If it is too high, the purchasing power of the citizens decreases. As such, they buy fewer goods and services. In the long run, the economy slows down since money is not circulation well.
On the other hand, slow inflation, or deflation, is also risky to the economy. Low prices of goods and services mean that investors are not making enough money. They might opt to quit the businesses or offer insufficient goods and services. This, too, weakens the economy.
It is the role of Central banks to see to it that the rate of inflation is kept at healthy levels. They use measures such as Producer Price Index, PPI and Consumer Price Index, CPI to rate it.
What is Interest Rates?
We also need to know what interest rates mean.
In definition, the interest rate is the measure of the amount that a lender is loaning money to a borrower.
If you can recall when you wanted a loan from the bank or someone, they said that they would charge you a figure like 8% per annum. The charges, or the extra money that you return on top of what you borrowed, is the interest.
The interest rate of a country is important in that it controls the economy. Just like inflation rates, interest rates are observed and managed by the Central Banks.
So, the Central Banks determine the interest rates of a nation by lending money to commercial banks. If they lend them money at a high basic interest rate, then the banks will pass the rates to the consumers (us). This means that we have to pay more for loans. The high fees translate to less money left to spend on goods and services. Thus, the economy slows down.
Interest rates can be lowered to stimulate a slow economy. Lower interest to the commercial banks means cheaper loans for us. When we get the loans at lower fees, our purchasing power increases such that we can spend more on goods and services. Due to this, both investors and consumers benefit, and the economy grows.
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Now comes the big question: “how are interest rates and inflation-related?”
We are going to look at this relationship in terms of what happens when each increase and what happens when each decreases.
Let’s start with the Effects of increasing.
⭐ 1. THE EFFECT OF INCREASING
● Interest Rate
When the interest rate is increased, the inflation rate decreases.
Remember that a high interest rate means loans are expensive to the banks and, ultimately, the borrowers. During such times, investors find that saving money will attract higher returns than borrowing. Therefore, they will save more and spend less.
From this phenomenon, we can say it is true that:
〉 The circulation of money in the economy decreases. The borrowers will opt to ignore the loans and prefer saving. Again, due to reduced purchasing power, the movement of goods and services reduces, and there is less money flowing from hand to hand.
〉 The demand for goods and services decreases. Due to the increase in the prices of commodities and services, the consumers spend less on the same. Therefore, there will be less demand.
〉 In the end, the prices of goods and services fall. This is true because decreased demand leads to oversupply, which, in turn, leads to a decrease in the prices of goods and services.
When inflation increases, the interest rate decreases.
When the Central banks lower their lending rates, the commercial banks also lower theirs. The result is that both borrowing and saving attract very low returns for the consumers. As such, they will opt to invest their money elsewhere where they can get more returns than by saving. Therefore, saving in the banks will be discouraged and borrowing will increase.
From this relationship, we can conclude that when inflation increases:
〉 The circulation of money in the market increases. This result comes from the lowering of interest rates which means the borrowing rates are low. As such, more people and businesses can afford loans. Also, more money will be in circulation and not in savings accounts.
〉 The cost of borrowing becomes cheap (due to lower interest rates set by Central Banks).
〉 The demand for services and goods increases. When people can access funding at fair costs, they have surplus money to spend. As such, they will purchase more goods and services. As businesses notice the increasing demand, they also increase their stocks.
〉 The prices of goods and services ultimately increase. From the above point, we can see that the demand for goods and services increases. An increase in demand leads to a simultaneous increase in prices.
⭐ 2. THE EFFECT OF DECREASING
● Interest rate
If the interest rate decreases, then inflation increases.
Is this true?
Well, we have seen that when the interest rate is reduced, more people can borrow money. Also, they prefer borrowing and spending than saving.
When the above happens, we have a lot of money to spend over a limited supply of goods. In short, there will be more demand than supply.
Once the providers of goods and services notice the increased demand, then they hike their prices. Do you remember what we say when the prices of goods and services increase? That inflation has increased.
So, our above statement is true.
The other effects of a lower interest rate include:
〉 An increase in the circulation of money in the market
〉 An increase in the demand for goods and services
〉 Cheaper borrowing costs
〉 An increase in the prices of goods and services
If the rate of inflation decreases, then the interest rates increase.
Let’s investigate this.
When inflation is low, it means that the prices of goods and services are changing, albeit slowly. During this time, people will afford anything that they want until they do not want more. In short, demand will fall. They will also realize that saving earns them more than borrowing. Therefore, for the economy to get stimulated again, the interest rates increase.
Therefore, we can see that low inflation stimulates the increase of interest rates.
Other effects of low inflation are:
〉 A reduction in the amount of money circulating in the market
〉 More saving and less borrowing
〉 A decrease in the demand for services and goods
〉 Reduction of demand will cause a drop in the prices of goods and services
〉 An increase in the cost of borrowing
It is common knowledge that foreign exchange, Forex, is largely affected by the economy of a country at any given time.
For instance, when the economy of Canada is doing well, its currency will be strong. Investors will prefer using it due to its increased purchasing power.
In light of this, we can see a direct correlation between inflation and interest rates with forex.
● Interest Rate
When the interest rates in a country are high, it is usually a sign that the economy is doing. A country with a good economy means that the strength of its currency will increase.
In short, the demand for the local currency will be high. This, in turn, leads to its shortage, and ultimately, a higher value.
Therefore, we can say that the higher the interest rate of a currency, the stronger the currency is.
Forex traders can take advantage of such a currency to make money. They use the stronger currency to buy the weaker one through executing “buy” trades. Similarly, they can use the weaker currency to open “sell” trades and make money from its weakening value.
Higher interest rates also mean that a person makes more returns from their money in the bank. In this way, investors can take advantage of countries with higher interest rates and invest their money there. When they convert their money back to their local currency, it gives them worthy returns.
Inflation is a little tricky when it comes to affecting foreign exchange.
One, we know that when the inflation rate of a country is too slow (deflation), it means that the economy has stalled. The direct effect of this on the currency is that it will be weak.
Two, high inflation can discourage the flow of currency and the exchange of goods and services. These factors can lead to the poor performance of an economy and the concurrent weakening of its currency.
Moderate inflation, on the other hand, is healthy for the economy and the currency. In this instance, the prices of exports will be higher since the goods and services are better priced. When this happens, the local currency grows.
Forex traders can take advantage of expected moderate inflation to make trades. When a country is expected to announce moderate (fair) inflation rates, then they expect its currency to increase in value. As such, they can open “buy” trades and wait for the growth to happen.
On the other hand, if deflation or excess inflation is expected, they can take advantage of this information by selling the currency that is expected to weaken.
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Clearly, inflation and interest rates are conjoined twins attached at the heart. They exist as one and cannot be separated through any means.
Also, we can say that the relationship between them is inverse. When the interest rate increases, inflation decreases. Also, when inflation increases, then the interest rate decreases. The connection between them is crisp and clear.
We have also seen that the two economic indicators affect foreign exchange. High interest rates mean the affected currency will grow strong. Conversely, deflation and too high inflation weaken a currency. Therefore, these are important factors that traders should consider while making their investment decisions.
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