Interest and Inflation: A Brief Overview
Written by: Steven Luo, first year Medical Sciences
Photo credit: Unsplash by Ferran Fusalba Roselló
The terms “interest rate” and “inflation” are fixtures in the news. The financially-savvy pay close attention to these two single-digit numbers. They don’t look like much, but they can cause stocks to tumble and companies to crumble. To attest to the importance of interest and inflation, I’ll mention that if you visit the main page of the Bank of Canada official website, it will be impossible to miss the two figures for interest and inflation, set smack in the middle in over-size font. For the working adult, knowing exactly what they mean and why they’re important can help make financial decisions. Anyway, it’s a mark of maturity when a person starts to care about interest rates and inflation. So, let’s dive in.
One of the characteristics of a healthy economy is inflation. Inflation is the rise in the nominal (explicit) cost of goods and services. Another way of viewing inflation is as the decreasing purchasing value of money. If a dollar today is worth less than a dollar yesterday, a chicken wing that cost me ten dollars yesterday will cost me eleven or twelve today (assuming the inherent value of a chicken wing is the same). Canada’s target for inflation is 2%, meaning costs should increase by 2% in a year.
Two major causes of inflation are government expenditure and supply shortages. In the former case, when the government increases the amount of currency in circulation through contracting projects, cutting taxes, or writing stimulus checks, there is more demand for goods, causing prices to increase. In the latter case, when essential goods are in shortage, competition among consumers leads to businesses pricing goods higher. This was a primary cause of the drastic inflation during the pandemic, when the production and transportation of internationally-sourced goods all but halted.
Most economists agree a certain degree of inflation is beneficial. Inflation encourages spending and consumption. For example, the economist John Keynes believed inflation discouraged consumers from hoarding cash and waiting for lower prices (as inflation ensures prices will not drop), thus stimulating business.
On the other hand, excessive inflation can be detrimental. It can run companies out of business from insurmountable costs of operation. In addition, it increases strain on families due to increased costs of living. Finally, inflation hurts retirees, who no longer have incomes and thus rely on previous savings, which devalue with time.
Central banks conduct monetary policy to control national inflation (as opposed to fiscal policy, which is determined by Parliament). The central bank in Canada is named The Bank of Canada. It is affiliated with the Canadian legislature but is governed separately and (ideally) non-politically, much like the Supreme Court. The main way The Bank of Canada keeps inflation at healthy levels is by influencing interest (the cost of borrowing money) and thus commercial activity in Canada. Businesses rely on bank loans to start and expand. Consumers rely on loans to invest, buy homes, and make purchases. However, if borrowing money is too expensive, businesses and consumers are discouraged from taking out loans, economic activity stalls, and inflation slows. Conversely, if loans are cheap, businesses and consumers are encouraged to borrow money, economic activity accelerates, and inflation rises.
The oft-mentioned “interest rate” ubiquitous in media and newspapers is formally known as the “federal funds rate” in the U.S. and “policy interest rate” in Canada. However, neither of these terms conveys its meaning any more clearly. The interest rate is not some kind of sweeping constraint on loan rates. Rather, it is a target central banks set. It is the interest rate commercial banks charge other banks to make overnight loans. Central banks consider this overnight rate to be a good index of the overall cost of borrowing money, because if commercial banks are charging high interest rates on overnight loans, they are likely also charging high interest rates on other kinds of loans, such as mortgages, business loans, and personal loans.
When banks announce specific raises or drops to interest rates, they are referring to changes in their target for this overnight rate. Central banks do not force commercial banks to use this rate; instead, central banks use a variety of ingenious tactics to naturally encourage banks to lend at the desired rate.
One of the most common techniques is referred to as “open market operations.” Central banks either buy or sell government bonds to commercial banks to influence the amount of money banks are willing to lend to consumers. Government bonds are akin to loans to the government; it is money paid to the government in return for regular interest payments and an eventual repayment of the principal loan. They are considered virtually risk-free, as they are backed by the government’s tax collection (and if the government has weakened to the point of being unable to collect taxes, not being paid back is the least of a person’s worries).
Commercial banks generally have some amount of their assets invested in government bonds. When central banks sell bonds to commercial banks, commercial banks gain bonds but lose cash. Conversely, when central banks purchase bonds back from commercial banks, commercial banks lose bonds but gain cash. The central bank does not force commercial banks to buy or sell – remember, these are “open market operations.” Instead, supply and demand interact to set the price of government bonds so that either selling or buying would be favourable to the commercial bank. For instance, when central banks decide to buy, they pay more to buy bonds, which benefits commercial banks because they get paid more. When central banks decide to sell, they sell bonds for less, which benefits commercial banks because they buy a valuable investment cheap.
Commercial banks generally hold a certain percentage of their assets as cash in reserve to pay back depositors. So, if they are lending money to the government, they have less money to lend to consumers and businesses, as they cannot dip into their reserves to replace the money loaned to the government. If the demand for loans remains the same, banks can increase their own interest rates. Thus, rising interest rates for commercial and personal loans are a consequence of a reduced amount of cash available for lending. Similarly, if they receive money from the government, they have more money to lend, and thus lower their interest rates to encourage borrowing.
A recent example of central banks attempting to control inflation was during the COVID-19 pandemic. At the start of the pandemic, inflation in Canada was low, dropping to -0.4% in May 2020. Fear was the suspected culprit, as pandemic-scared Canadians cancelled their summer vacations, got rid of their investments, and hoarded cash. A negative inflation rate meant prices were actually dropping – does anyone else remember the stories about dairy farmers paying customers to take milk off their hands? In response, the Bank of Canada cut the overnight interest rate from 1.25% to 0.75% on March 16, 2020, and then 0.25% on March 26. The decreased interest rate, coupled with supply shortages, led to rampant inflation, reaching 8.1% in June of 2022. In suburban Toronto, house prices skyrocketed by as much as 50% in those two years. By that point, the Bank of Canada had decided low-interest rates could no longer stand. On March 2nd, 2022, after two years of nearly zero interest, the Bank of Canada upped its target to 0.50%. This became 1.00% in April, 1.50% in June, 2.50% in July, 3.25% in September, 3.75% in October, and 4.25% in December – a 4% increase in 9 months. Currently, the Bank of Canada policy interest rate sits at 5.00%, while the inflation rate has come down to a reasonable 3.1% (as of November 2023).
Sometimes, central banks’ policies do not work, and when they do, their desired outcomes are often delayed. In addition, sometimes the relationship between inflation and interest rate is not so simple as inflation high, interest rate low, and vice versa. However, although people are generally cagey about money, economic authorities like central banks demonstrate remarkable transparency. I encourage those of you interested in the topic to do your own research. I’m no expert on centralized regulation of inflation; everything I’ve written here came from an OpenStax Macroeconomics textbook and publicly accessible documents on the Bank of Canada website. And the more I’ve learned about the subject, the more I’ve come to realize all that stands between prosperity and financial anarchy are the two figures in bold on www.bankofcanada.ca.
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