Let us understand some terms before we examine the topic in detail! Inflation is a term used to define the increased prices and value of services in an economy. This index changes yearly and is caused due to higher rates of taxes, and disproportionate supply and demand of money.
Inflation is useful for maintaining growth and representing a healthy economy. An inflation rate of 2-3% is favorable to the government as people tend to borrow more and buy more due to low-interest rates caused by lower inflation.
As responsible citizens, we must form an understanding of how the financial structure of our country works as it may directly or indirectly affect us and our prospects.
1. Interest Rates and Bank Rates
Imagine borrowing money from a lender or a bank. To make this advantageous for the lender, you will be required to pay back more than you borrowed. A certain amount adds up to the borrowed money over time which is known as the interest rate.
To ensure less compensation amount, the interest rates should be as low as possible. All banks set their interest rates, but it is heavily influenced by the rate the central bank sets.
On the other hand, if you have a savings account with a high-interest rate, you will be able to save more as a bonus for keeping money in your account. This bonus depends on the set of conditions put forth by the bank which holds your account.
Thus, bank rates and interest rates go hand-in-hand as bank rates are set by the reserve bank of the country and remain fixed for every commercial bank across the country while interest rates are set by commercial banks and differ from bank to bank.
1.1. Why Do Central Banks Raise Interest Rates?
A central bank is an authoritative body which controls the formulation of laws and policies regarding finance. They are responsible for forming the financial structure of an economy and creating monetary policies for the regulation of interest rates. We will develop a deeper understanding of monetary policy for different countries as we progress further.
Raising interest rates acts as a powerful tool to control inflation. Central banks like The Bank of England and The European Central Bank have a goal set to achieve 2% inflation.
When this rate exceeds the limit, central banks raise interest rates, which naturally affects the rates of all commercial banks across the country. This weakens the effect of inflation by causing changes in the gross national statistics of finance.
2. How Inflation Affects Businesses and Consumers?
When central banks increase interest rates, it is an attempt to control the rising prices for consumers and businesses. The increase in prices affects economic growth as people refrain from buying items, day-to-day requirements being an exception. Money loses its value, and fewer things can be bought.
In the field of business, higher inflation rates can cause less consumer interaction and changes in work ethics and employees.
The higher the inflation rate, the less number of employees a start-up or even previously prospering companies and organizations would be able to afford, as it has a higher probability of causing an imbalance between a work period and wage.
When the reserve bank increases interest rates, borrowing and investing money becomes an issue. This may cause a shortage in job availability and economic development. Businesses try to overcome this by launching new schemes and sales to maintain consumers and avoid losses.
Talking about the consumer point of view, inflation causes major changes in the expenses and usage of services. Everyday items feel like a luxury, and people going through low financial footing suffer the most.
Consumer behaviour varies from cutting off from brands and buying items owned and created by general stores, which results in profit for the private company, to buying items in bulk, which is a strategic move from the business owners.
Let us understand this through an example:
The inflation rate is currently high in your country, and there is a sale in a general store located 15 km away from your place of residence. Considering the economic situation, we try to get the most out of this opportunity. We travelled to the store and were satisfied with the bill we received. What we fail to notice is that the gas or fuel used to travel to the store makes up for the missing amount in our bills.
2.1. Effects On Your Savings
Saving money in the form of cash would neither benefit nor deprive you of your savings during times of inflation but can affect your purchasing power. Inflation rates can prove to be beneficial to your bank accounts, but the real interest rates demand attention.
While higher interest rates can help you grow your savings account, it is important to acknowledge that this may not be the case every time. The requital amount being lower than the inflation rate can negatively affect the real interest rate.
3. Where Does Monetary Policy Fit In?
Monetary policy is a policy set forth by the central bank which deals with objectives like consumption and inflation through the management of the money supply and the rate of interest. As inflation reaches the highest level (compared to the goal of a 2% increase per annum), central banks raise interest rates to lower the rate of inflation.
Higher interest rates affect the expenditure of people, which results in people being encouraged to save and spend considerably. If household spending is reduced, the average household price rises and decreases the inflation rate.
3.1. Monetary Policy for Different Countries
Each country has a unique economic situation, which is why currencies are different for every country. The central bank of each country sets out their monetary policy according to the needs of their respective financial systems.
3.1.1. The United States Federal Reserve
The Federal Reserve was created in 1913 when the legislation of the Federal Reserve Act was passed. To set a monetary policy for the American economy, the Federal Reserve uses three tools: Discount rates, Open market operations, and Reserve requirements.
The main objectives of the Fed are to ensure maximum employment opportunities, to provide stable incomes, and to moderate and monitor the interest rates that impact the financial system. The Monetary policy conducts these affairs.
3.1.2. The European Central Bank
The European Central Bank, or ECB, aims to achieve the goal of price stability through its monetary policy. The Monetary Policy Committee issues rulings every six weeks to maintain their target rate of 2% inflation. The ECB uses open market operations to navigate interest rates and indicate the standpoint of their monetary policy.
3.1.3. The Reserve Bank of India
The Reserve Bank of India aims to operate its credit system and currency in a way that is beneficial for economic growth. The RBI lays down its monetary policy frameworks considering the evolving economy while maintaining its goals in perception.
Monetary Policy Shapes Global Investments
Eric Croak, CFP, the President of Croak Capital, discusses significant ways Central Bank Monetary Policies shape the global economy:
“Major central banks and their monetary policy can affect global investments. For example, the Fed can impact how well stocks, bonds, and other investments perform.
The Federal Reserve and the European Central Bank (ECB) play significant roles in the global financial market, influencing not just local but international investment trends.
When the Federal Reserve or the ECB adjusts interest rates, it can lead to global ripples affecting the price of stocks, dividends, bonds, and other investment products.
For instance, if the Federal Reserve raises interest rates, it can strengthen the US dollar. This impacts global markets as a stronger dollar can mean weaker foreign currencies, affecting international trade and investment.
Foreign stocks might become less attractive to US investors, and vice versa, leading to shifts in global stock prices. Similarly, the ECB’s monetary policies can significantly impact the Eurozone and beyond.
Changes in ECB policies can influence the euro’s value, affecting European exports and imports. This, in turn, can impact global stock markets, particularly in countries closely tied to the Eurozone economy.
Global corporations are also affected. For instance, if the Federal Reserve increases rates, borrowing costs for global companies might rise, affecting their profit margins and investment plans.
This can influence their stock prices and the dividends they pay to shareholders.”
4. What Might Be Coming Next?
The changes in the inflation rate are calculated using the Consumer Price Index, which works by tracking the changes in most commonly used services and items. CPI is a useful tool for determining inflation and deflation in an economy.
4.1 How Will We Overcome Inflation In The Coming Years?
Being financially prepared by saving and choosing the right financial instruments according to your needs should be the starting point of the process.
Planning out your finances and changing your buying and spending habits, setting a particular order for your finances to reach your long-term and short-term goals based on your income growth is another way to secure your financial stability from future uncertainties.
In the coming years, the biggest problem for the government to tackle would be the increasing demand for work and not enough jobs to maintain the required balance. The Federal Reserve’s goal is to control inflation by restricting interest rates. If one rises, the other will adjust accordingly.
Governments have significantly fewer ways to stop inflation. Price controls can cause adversities in the economy and can cause the opposite of the effect they intend to portray. A Government should update its policies and rulings frequently to encourage economic growth.
Diversify with TIPS and Real Assets
Michael Dion, the Chief Finance Nerd at F9 Finance, presents financial strategies to protect your savings against inflation:
“I’ve come to rely on a couple of strategies and financial instruments that can serve as effective hedges against inflation. Firstly, investing in Treasury Inflation-Protected Securities (TIPS) is a strategy I highly recommend.
TIPS are government bonds specifically designed to combat inflation, as their principal value adjusts with inflation rates, reflected in the Consumer Price Index (CPI).
This adjustment ensures that the interest payments and the eventual payout upon maturity are not eroded by inflation, making TIPS a solid choice for preserving the real value of your savings.
Another strategy is diversifying your investment portfolio to include assets that historically perform well during inflationary periods.
Real assets like real estate and commodities, including gold, have shown resilience in the face of inflation. Real estate, for instance, tends to benefit from inflation because property values and rents typically increase when prices do.
Similarly, commodities like gold are often sought after as a store of value when fiat currencies are losing value due to inflation. Including such assets in your portfolio can provide a natural hedge against inflation.”
Conclusion
The policies and schemes set out by the government and the central bank vary with time. What you need to ensure is that you are prepared and ready to face the obstacles the economy of your country might face while being secure with your prospects and stature.
Guest Author: Saket Kumar
Last Updated on July 11, 2024 by Sathi Chakraborty