Interest Rates & Inflation
Posted by John Draper | Filed under Economics 101, Take Control
Imagine that you’re selling lemonade. It’s a hot day and there’s a big demand for a long, cold glass of you’ve got. You can probably charge two bucks a glass and get away with it. Yup, thirsty people won’t think twice about shelling out for a little lemony relief. And if you’re down to your last glass or two, someone may offer a premium, coughing up an extra fifty cents to grab a glass. So, when supply is low and demand is high, prices jump. Of course, if your next-door-neighbours all decide to set up their own lemonade stands, you’re going to have to practically give it away to get it off your hands. And if the weather suddenly changes, a cold wind blowing the leaves and your customers’ thirst away, nobody is going to pay a red cent for your lemonade.
What’s true for lemonade is also true for money. When there’s more money than stuff to buy, prices go up. When there’s more stuff than money, prices go down. Inflation is the measurement of the changes in prices of all that stuff.
Enter interest rates. The lower the interest rates, the less it costs to borrow so there’s money to buy stuff.
Think of interest rates as the price of money. The central bank is in charge of deciding the cost of money overall, so it is the central bankers who set the interest rate. When central bankers raise interest rates, they make money more expensive and so the demand for it goes down. The less money available to buy stuff, the more pressure there is on prices to come down. That’s why higher interest rates lead to lower inflation.
Of course, if the central banker decides to raise interest rates to fight inflation, that means that the economy is going to slow down. After all, if nobody has the money to buy TVs, then the company that makes TVs is going to make fewer, so they’re going to lay off some TV builders, who then won’t have the money to buy food, never mind TVs. And that’s why the interest rate/inflation dance is such a precarious one.
Whenever there is news about the changes in the central bank rate, most people’s eyes glaze over. We know if rates go up, that’s no good for borrowing. But that’s about all we know.
At the turn of the new century, our central bank, the Bank of Canada, introduced a new system of eight “fixed” or pre-specified dates each year for announcing changes to the official interest rate it uses to implement monetary policy. Since the rates could no longer be changed on any day in response to an economic ill wind, this was seen as a good way of stabilizing interest rates. Central banks in Europe and the U.S. Federal Reserve also use this system. Of course, the central bankers reserved the right to make a change off schedule under extreme circumstances.
The Bank of Canada sets interest rates with the objective of keeping inflation between 1- 3%, with an optimal target of 2%. So when the inflation rate hit 3.1% last July (over July 200&), it was the biggest jump we’d seen since September 2005. Then in August, inflation jumped again by 3.5%. Ooops.
Of course, the central bank’s decision has an impact on our ability to borrow money. And while many a lender has been holding the line – not raising rates – to keep customers coming through the doors, those days are drawing to a close. Expect to see higher interest rates as lenders themselves find money is tight and they must pay more.
When rates go up, it isn’t all bad news. Only the borrowers suffer. The savers jump up and down clapping their hands because their deposits are working that much harder. While, typically, periods of high interest rates are associated with periods of high inflation, as with everything else, things will change again. If interest rates jump way up, you should consider buying investments that will hold those higher rates for as long as possible.
Start your research on various interest-based investments now. Learn about options like mortgage-backed investments (don’t laugh), the various types of bonds, and mutual funds that are based on fixed-income investments. Figure out what TIGRs and STRIPS are. Learn the language of investing — including all the stupid acronyms — so you’re ready to take advantage of what comes next.
We are leaving the age of rampant borrowing. Who knows what age we’re entering next. As with everything else in life, the changes are painful. But the opportunities are great. Get focused. Know what you want. Get educated. Take advantage of what the future holds. Become an OWAP…. an Optimist With A Plan!
October 7, 2008 at 8:38 am
Stay away from the Fools…please. They’re so bad. They have decent resources, but stay away from their actual philosophy.
October 7, 2008 at 8:45 am
2nd rm’s advice.
October 7, 2008 at 11:33 am
Good simple way of explaining the way interest rate adjustments by the Bank of Canada affects overall money flow. The explanation in general is rather simple but to fully understand the dance between macro- and microeconomics is a complex one. But fun at that!
October 7, 2008 at 12:02 pm
Thanks for the link Gail. TD Bank announced today that it will charge 1% more on variable mortgages and secured lines of credit. It’s great to be debt-free anytime but especially so in bad times.
October 7, 2008 at 9:48 pm
You explained it so well, thank you.
October 8, 2008 at 12:07 am
I just about died laughing today when I caught up on the latest/newest episode of Til Debt Due Us Part. I have always loved you Gail, but when you said “repeat after me…I am a dickwad” I thought I was going to split my gut.
You are so funny! Anyway…great show as always.
April 23, 2009 at 6:26 pm
A few years ago we got a secured line of credit from CIBC using our house as equity. We went through lawyers and it was registered. Now, they have the nerve to say they are going to charge us 1% over Prime. Why, I don’t understand. This was a legal document. How can they change from charging me Prime to 1% over prime., except they are worse than black market or mafia money lenders. How much does the Central bank charge banks to boprrow money. If prime is now .25% how do they justify 3.25 %? We carry no credit card debts, Paid off monthly, only debt is L of Credit. Tired of Banks nickel and dimeing us to death.