Hi there accounting fans! Let’s talk about inflation and interest rates!
No matter where we live in the world, we are suffering the effects of the COVID-19 pandemic. Apart from the obvious health effects, COVID-19 has also affected economies around the world. As countries like Malaysia enter a recession, we enter a new and unpredictable financial era. We will hear more from central banks about inflation and interest in the near future. In the ‘interest’ of keeping things simple for my readers (pun totally intended). Let’s talk about these two fundamental concepts of economics.
What are inflation and interest rates?
This article was inspired by the most recent news in New Zealand that inflation has risen due to strong economic growth. While many countries around the world are experiencing recessions, New Zealand seems to have the opposite problem. Strong domestic economic growth have led to increased demand for goods and services which in turn drive inflation.
What is inflation then?
According to the Reserve Bank of New Zealand (New Zealand’s central bank). Inflation is a rise of average prices in the economy. Inflation is driven by a lot of different factors such as:
- The supply of particular goods
- The demand for particular goods
- Laws/policies which affect the supply and demand of particular goods
Let’s take a simple example:
There has recently been a strong demand for new building developments in New Zealand. This has increased the demand for raw building materials such as timber. There is only so much local timber producers can supply. Since they cannot possibly supply enough to meet ALL of the demand, they increase the cost of timber to service the customers who can afford to pay.
Naturally, when the price of one commodity increases, this has a knock-on effect to other commodities. To continue the example:
With higher cost of timber, new buildings are more expensive to build. Builders increase the prices of the houses they build, which causes the average prices of houses to rise. This, in turn affects the average rent as landlords seek to recover their costs on newly built houses by passing on the rise in costs to their tenants.
Is inflation bad?
No. Inflation isn’t bad. In fact, controlled inflation is a good sign of a healthy, growing economy. If left unchecked, over-inflation can cause boom and bust cycles. Boom cycles happen when prices of goods go up SO MUCH due to increased demand that it shuts out many consumers from the market. Bust cycles happen when due to the hyper inflated prices consumers stop buying, leading to many producers and businesses dropping their prices to attract customers back (assuming they survive the initial lack of demand for their products/services).
Boom and bust cycles aren’t good for long term economic stability. So central banks around the world utilise economic tools to control inflation. One of the most important and popular tools are interest rates!
Interest rates to the rescue!
A steady, controlled level of inflation means that there is sufficient supply within an economy to keep up with the demand and vice versa. This implies a good relationship between suppliers and consumers where suppliers sell goods at a price that is acceptable for consumers. If left to its own devices, the ‘free market’ is very prone to boom and bust cycles. So central banks influence the overall inflation rate in a country by setting interest control rates.
In New Zealand, the Official Cash Rate (OCR) is the name of the interest control rate. Other parts of the world call them Base Lending Rates (BLR). The higher the OCR/BLR is set, the higher the overall interest charged on bank accounts and loans throughout the country. The lower it is set, the lower the overall interest rates in the country.
How does this affect inflation?
Easy.
When interest rates are high, businesses are less keen to borrow money (because of expensive interest payments) and are less likely to buy stuff to sell. This slows down business expansion, which also slows down the price increase of goods and services overall. Individuals are also more likely to save their money (instead of spending it) in term deposits or other low risk investments because they can get higher interest rate returns on those investments.
When interest rates are low, businesses will borrow more money (because interest payments are cheap) and will buy and sell more stuff. This encourages business growth, which then increases the price of goods and services. Individuals are more likely to borrow to take advantage of the low interest rates. This is when people buy their fancy houses, boats, cars, planes, etc.
So when the central bank sees that inflation is increasing, they crank up the Interest rates and get people to slow down on spending. When inflation is decreasing or if they foresee a recession, they ease down the Interest rates to get people spending again. This is why the Reserve Bank had set the OCR to a low 0.25% at the height of the pandemic crisis here in New Zealand in March 2020.
Why are inflation and interest rates so important?
Ok, so think of a nation’s economy as a bouncy castle. To keep a bouncy castle, ‘bouncy’ you need to pump it up with air to keep it inflated. An inflated castle is bouncy, everyone has a great time bouncing around. However, an over-inflated castle makes your bouncing becomes bigger and less controlled, increasing the chances of accidents. Too much inflation and the bouncy castle will explode!
This is why bouncy castles have air valves to let air out to maintain the correct level of inflation. Let too much air out, and the castle will become deflated. No one likes a deflated castle! Where is the fun in that???
So yes, inflation helps keep the economy up and ‘bouncy’ and interest rates are the air valve that controls the levels of inflation that an economy experiences.
If inflation reverses, this is known as deflation. Deflation IS bad. This implies that people are too scared of their financial future to even spend money. This forces businesses to drop their prices to attract customers. This usually happens when an economy is stuck in an economic depression (which we can all agree is a BAD THING).
What level of inflation do we need to keep the economy ‘bouncy’?
Good question.
Central banks monitor the inflation levels constantly and calculate a Consumer Price Index (CPI). This CPI is made up of the average price of goods and services in a country. Inflation is calculated by monitoring the increase/decrease of these goods and services. Generally speaking, an inflation rate of 1-3 percent is considered to be acceptable. Anything higher than that will force a change in monetary policy.
Most recently, NZ’s annual inflation rate in 2021 was announced at 3.3% – just a smidge higher than the band of 1-3 percent. This inflation was driven by an overall robust economic recovery from COVID and general positive spending sentiment in the country. The government subsidies helped a lot as well.
This means that we can expect an increase in the OCR which will increase interest rates in NZ.
Sit tight, wait for the interest rate announcement and as always,
Stay positive!