RELATIONSHIP BETWEEN INTEREST RATES AND INFLATION

It is typically a positive relation. In other words, both tend to move either up or down together. However, the caveat is that interest rates will always follow inflation rates or, put simply, when inflation goes up, interest rates go up and when inflation comes down, interest rates tend to fall.

The reason behind this relationship is fairly simple as also complex. Inflation tends to happen when an economy is `overheating' much like what is happening in India now. Of course, inflation also happens when central banks print a lot of money or when macroeconomic policies go bad. However, in this case, let's assume that the central bank and government are largely following `correct' policies. This assumption is necessary because the relation between inflation and interest rates becomes clearer.

Money is the engine of any economy. Let's start from the time when money is cheap or in other words, there is a low interest rate. This is also called `loose money policy'. Because of this cheap money, people borrow to start businesses, invest and so on; the price they pay for the money is interest. Over time, a virtuous cycle gets created where this money generates more money and people tend to become richer.

India is the best case where this has happened in the last few years. Interest rates were low in India and people and companies have borrowed liberally for a variety of things. People bought houses, cars, TV sets and so on and companies built factories, etc. When this happens, economies will typically go through what is known as a boom phase with GDP, incomes, and profits rising rapidly. All this increases the demand for goods and we all know that prices of goods depend on demand and supply. Over time, demand builds and slowly outstrips supply as is happening in India now. When that happens, prices of goods tend to go up and that results in inflation because most of these goods are usually part of a basket that constitutes the Wholesale Price Index or the Consumer Price Index.

To `cool' the economy, central banks will raise interest rates. The intention here is to slow demand and, in effect, decelerate the economy. However, this is a tightrope act because interest rates must be raised just enough to cool the economy but not send it into a recession. When interest rates are increased, money becomes costlier and that is known as `tight money policy'. What the central bank hopes is that when it increases rates, people and companies will borrow less and therefore there will be less purchases and investments. This usually cools the economy. During this cooling period, GDP growth usually slows, companies' profits are reduced and people are less likely to spend. Over time, inflation drops and as it does, the central bank will usually lower interest rates to again kick-start the economy and the cycle continues.

However, it is important to understand that the above explanation is very broad and that there are many factors that go into this sometimes complex relationship.

- The article has been written by Sunil Rongola who is Economist, Murugappa Group. The views expressed are personal and has appeared in Hindu todya