What everybody ought to know about inflation and interest rates (Part 1)

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A short while ago I was talking to a highly educated and well-informed friend of mine about mortgages and how she wasn’t sure if she was on the right one.

She told me one of the main reasons she doesn’t know is because she is scared to question the bank’s mortgage recommendation. Despite being a successful businesswoman, she doesn’t understand the economic jargon about inflation and interest rates and she feels silly when talking with her mortgage adviser.

What you should know about inflation over the outline of a globe

That made me think. I’m a passionate amateur economist and will quite happily cross-examine any mortgage advice provided by my bank. (Last time it likely saved me about £50k.) 

But, when discussing economic issues, as when discussing investing, it’s common for people to use specialised terms, especially in the media.

In fact, using these terms has become so commonplace that it’s just assumed everyone knows what they mean. But, often we don’t.

Well, so what?

Banks are businesses. They make money by charging interest on products like mortgages, loans and bank accounts. The higher the interest rate and the longer the loan, the more money the bank can make from the customer who purchases the mortgage – you.

My bank tried to use my assumed lack of knowledge about interest rate movements to sell me a mortgage that was better suited to the bank than to me. 

But knowledge of inflation and interest rates meant that eventually I got the right mortgage for me, and saved myself about £50,000.

It’s really important we know as much as we can about inflation and interest rates.

So, if you ever ask what’s the difference between inflation and interest rates and how do they both affect your savings and your mortgage? Then this post is for you.

It’s the inflation and interest rates relationship explained – something very useful to know.

(NB. I’ve broken this post down into two parts. This is Part 1, Part 2 is to follow.)

What is inflation?

Inflation is a general rise in prices that happens because of too much money in circulation.

Moreover, one of its symptoms is a drop in the number of goods and services you buy and sell with your money, known as a drop in purchasing power.

Prices rise for the same reason the price of anything rises – more is demanded than can be supplied at a particular price. When we have more money, we tend to spend more!

How do prices change over time?

Prices fluctuate because of the ever-changing ratio between demand and supply of goods and services.

And there are many reasons why this can happen.

One such way is when an increase in the amount of money in the economy stimulates demand.

Demand-pull inflation

Take coffee.

A 250g bag of illy coffee currently costs me £6.50 ($8.00)  in my local supermarket. I usually buy one per week, as do many other illy customers from my area.

However, there’s an election coming up and to encourage people to vote for it, the government has given every household in the country an extra £6.50 this month! Hooray!

I decide to buy an extra tin of illy with my windfall.

As do many other illy customers.

This means demand for illy coffee has increased considerably, but illy’s supply and distribution chain can’t spontaneously adjust for the extra demand. (NB. If some of illy’s customers purchase two tins, there won’t be enough for others. So, an increase in purchasing power has resulted in shortages of tins of coffee on supermarket shelves. (This is what happened to certain goods during the Covid-19 pandemic.))

Illy needs to decide where it’ll send its coffee. For a business, the obvious destination is where it’ll make the most profit – the retailers where the prices have gone up the most.

So, for my supermarket to continue stocking illy coffee, it needs to raise prices, causing inflation.

Another way for inflation to occur is for costs to rise in the production chains of goods and services.

Cost-push inflation

Back to coffee…

There’s been a drought in Ethiopia where illy sources its arabica coffee beans. This means fewer coffee beans are produced for coffee manufacturers to buy.

In order to decide which coffee firms to sell to, coffee producers will sell to where they can make the most profit – those who will pay.

So, the coffee producer puts up its price for coffee. 

Coffee companies now buy coffee beans at this higher price to keep customers like me happy. But, sadly for me, for illy to recoup this extra expense, it now charges £7.00 ($8.80) for a 250g bag of coffee.

Bother.

Still, I get my coffee and the coffee producer gets compensated for his loss. So, not all bad.

There’s one last type of inflation worth mentioning and that is built-in inflation.

Built-in inflation

This type of inflation occurs when people expect rising prices to continue. Consequently, people demand more money to maintain their living standards.

Wages are often an organisation’s biggest cost. Because of this, it needs to recoup the money it spends on wages by raising the prices of its goods and/or services.

And so begins a wage-price spiral of rising wages and prices.  

Whatever the actual mechanisms that cause inflation, in the long run, more money means more spending. And if suppliers can’t keep up with our demands, it also means higher prices. 

Moreover, the rate at which this happens is key to our standard of living.

Why is the rate of inflation important?

The rate of inflation is a measure of how quickly prices go up. 

If our incomes don’t increase at the same speed we’re worse off because, relatively speaking, things are more expensive.

And this includes things such as bank accounts, loans and any other debts.

So, to be able to manage money effectively, we need to be able to measure the speed at which prices go up.

How do we measure inflation?

Governments measure inflation by comparing the current price of a set of goods and services to previous prices of these same items over a certain period of time, such as a month or year.

What’s in this set of goods and services? It depends!

The most widely used measure of inflation is the Consumer Price Index (CPI). This is the measure I use when working out portfolio returns.

The CPI uses goods and services that are regularly bought and used by people at home (known as ‘household consumption). Items include food, drink, tobacco products, clothing, bedding, housing, fuel and lighting.

The second measure is the Retail Price Index (RPI). This measures the changes in retail prices of specific goods and services and accounts for housing costs, such as mortgages, council tax, housing depreciation, solar PV feeds, etc

(Wall St Mojo has produced a great infographic highlighting the differences between CPI and RPI.)

One of the big issues we’re dealing with right now is the prices of many goods and services, whether measured by CPI or RPI, are going up faster than incomes. 

This is mainly due to Governments reopening economies after shutting them down, and the war in Ukraine restricting oil, gas and wheat supplies.

Will inflation keep rising?

Despite predictions to the contrary, the real answer is that no one really knows – it depends on so many factors. 

Prices and wages do not spontaneously adjust – they change as market conditions alter. The only certainty is market conditions never alter in a regular and predictable way, and there are always time lags. 

That said, the Bank of England (BoE) expects UK inflation to continue rising to about 10% this year. 

The US Federal Reserve is more optimistic about US inflation and is expecting a rise between 1.6% to 4.3%, depending on which agency you speak to! 

However, both central banks are expecting inflation to fall over the next couple of years due to their intended actions which I’ll come onto shortly.

Why does the Fed care about inflation?

It’s the job of a central bank to care about inflation because it affects monetary policy, the raison d’etre of an independent central bank.

After the Great Inflation of the 1990s – an odd name, I think! – several Western central banks were made independent of government. 

Many governments were inspired by the track record of the independent German Bundesbank in achieving lower inflation rates than in other countries and followed suit.

These banks became responsible for monetary policy – the control of money in an economy – which initially affects economic output and employment but eventually affects prices.

Inflation affects monetary policy which in turn affects economic prosperity and social welfare.

Unfortunately, it’s not realistic for a central bank to get rid of price fluctuations entirely but it can reduce the uncertainty that comes with them and stop people worrying.

In 2022, when inflation is on the rise, it seems strange to think that until recently we’ve taken price stability for granted. 

In fact, before the pandemic, many media commentators were even discussing possible deflation – when prices fall.

What is deflation?

Deflation is a drop in general price levels and an increase in the purchasing power of money. 

In other words, you can buy more with your money. 

If inflation is seen as bad, it’s tempting to assume that deflation must be good. It definitely sounds it.

However, when the supply of things that money buys grows faster than the money supply, prices drop. 

This means that we now pay any debts, such as mortgages, leases, contracts and any other legal obligations, with money that is worth less than it was when we took ut the debt.  In other words, debts become more expensive.

So, we now owe more than we did when we initially agreed to borrow the money. This adds to the likelihood of people defaulting on their debts, which is what happened in the US between 1930-1933. During this time, over 9,000 banks suspended operations, partly because mortgage holders defaulted.

In addition, deflation affects different prices in different ways.

For example, a business owner may find that the prices of what they sell fall faster than the prices of what they buy. Moreover, payment amounts on fixed assets like property stay the same.

So, you have a situation where the business owners are getting less money in but paying more out. This means profits, investment, and job opportunities will also decline.

Fewer jobs mean people tend to hold on to money in case they need it. This keeps more money out of the economy and slows down the speed at which it circulates as fewer things are bought and consumed.

This reduces demand which further reduces the jobs necessary to produce things.

And now we have a big downward spiral of gloom. 

Until the money supply is increased once again, usually by central banks using monetary policy using interest rates.

But, that’s for Part 2 of this blog post about inflation and interest rates – coming soon.

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DISCLAIMER: MY BLOG PROVIDES ONLY GENERAL INFORMATION AND IDEAS. IT SHOULD NOT BE CONSIDERED FINANCIAL ADVICE. ANY USE OF THE MATERIAL IS ON THE CONDITION OF THERE BEING NO LIABILITY FOR HOW YOU CHOOSE TO USE IT. IF UNSURE, PLEASE CONTACT A FINANCIAL ADVISOR. 

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