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The Relationship Between Inflation and Interest Rates

Writer's picture: Adam KempAdam Kemp

If you’ve had your finger on the pulse of the finance industry recently, you’ve probably heard frequently about rising inflation and rising interest rates. While investors and economists are fluent in finance lingo, these terms can be confusing for everyday Australians. To most of us, high inflation and interest rates simply mean our day-to-day living is becoming more expensive.


However, inflation and interest rates serve two very different purposes. Inflation measures a change in cost of goods and services, Interest rates exist as a countermeasure to help reduce inflation.


What is Inflation?

Inflation is a measurement used to track the rising cost of goods and services in a country. For example, you purchased a litre of milk for $1.55. Today you go to the store and purchase a litre of milk from the same brand for $1.60. Inflation for that milk would be 3.2%.


When inflation is high, it typically means people are paying more for their everyday goods and services, and regulatory bodies take notice. When prices are down, this is called deflation.


What is Interest?

While inflation extends to all purchases, interest is applied to debts and savings. If you open a bank account with a deposit of $40,000 at 5% interest per annum, you will earn $2,000 in interest over the year.


On the other hand, if you have a home loan at 5% interest, and your monthly principal repayment is $3,000, you will pay $150 in interest per month.


Rising interest rates are typically signs of high inflation, as interest is an effective way to combat inflation. Higher interest rates affect how much people looking for loans can borrow, reducing the activity in the market. This means fewer people borrow less money, and the economy can stabilise.


With interest rates remaining high, the hope is that inflation will begin to reduce. For reference, The Reserve Bank of Australia (RBA) raised its cash rate in November 2023, inflation was at 5%. A higher cash rate typically means higher interest rates from the banks.


While consumer spending is a key driver of inflation, it’s not the only one. Environmental factors regularly affect significant shifts to inflation. The Covid-19 pandemic greatly impacted the economy, and some experts equate today’s inflation as the result of high government spending during the pandemic, and high levels of consumer spending as lockdowns ended.


Inflation is currently on the decline, and it’s anticipated that the cash rate will follow suit, possibly in December this year or early next year, however, we can’t say for certain. Inflation could always go back up, meaning high interest rates need to be implemented a while longer.


If you have any questions regarding inflation, interest rates or just want to discuss your finance goals, reach out! I'm always keen for a chat.

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