Interest rates and inflation usually work in tandem. Rates tend to rise when the inflation goes up and tend to fall when it comes down. Understanding why that happens can help you decide whether to borrow money, plan to pay back loans and anticipate whether life is going to get more expensive. Though some connections between interest rates and inflation aren't obvious, their relationship usually makes sense when you look at real-world examples.
When companies experience inflation they have to spend more money to operate. They pay higher prices for supplies, raw materials, shipping and these increased costs can cause them to borrow money for growth and expansion rather than financing it themselves. That makes for increased loan demand, which can cause banks to raise their interest rates. Since they only have limited amounts to loan, banks see the increased demand as an opportunity to make more money from what they have. Therefore, the higher business costs that result from inflation can translate into higher interest rates.
As inflation raises the cost of doing business, banks find they make less money on loans. Their incomes remain the same while expenses go up, which means smaller profit margins. Consequently, banks tend to raise rates to compensate for their increased expenses. For example, if the cost of labor, supplies and communications rises 2 percent for a bank, loan rates have to rise at least that much to help income keep up with inflation.
Businesses and individuals like to make money on their money. If you have $1,000, you could invest it and earn interest. If, instead, someone wants you to loan them $1,000, you give up the interest you could have made. Inflation means your $1,000 buys less over time, so your money actually loses purchasing power during the loan period. To make up for the loss of value you could charge interest on the loan, just like a bank does. During periods of high inflation you must charge higher interest because you have more ground to make up when it comes to your money's value.
Borrowers can have a harder time paying back loans as inflation rises. Their living and business expenses go up during inflationary periods, squeezing their budgets so they have less to spend. If income doesn't keep up with inflation, people can reach the point where they can't pay all of their expenses. One of those expenses may be loan payments. Default rates can rise as a result and banks may then view the lending environment as having more risk, causing them to raise interest rates to compensate.
- Federal Reserve Bank of San Francisco: How Would a Change in Inflationary Expectations Affect Nominal Interest Rates and the Yield Curve?
- Federal Reserve Bank of Cleveland: Inflation, Banking, and Economic Growth
- PBS Newshour: The Business Desk-What's the Relationship Between Inflation and Interest Rates?
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