What is the link between inflation and interest rates?

Demystifying investment terms

Inflation is the rate at which prices for goods and services rise, and is measured as an annual percentage increase.

The usual way of calculating inflation is to take a number of everyday goods that are representative of the economy – clothing, food and petrol, for example – and put them into a notional ‘market basket.’ The cost of this basket is then compared over time, to indicate whether prices are rising (inflation) or decreasing (deflation).

An interest rate is the amount charged to a borrower by a lender. This too is measured as an annual percentage.

So how are the two linked?

Inflation indicates the cost of living rising, and is therefore a sign that an economy is growing. If it’s growing too fast, with prices rising faster than wages, then the government may raise interest rates. This discourages borrowing and encourages saving, which tends to slow the economy down – and decrease inflation.

Equally, if the economy needs a boost, interest rates may be lowered. Generally, lower interest rates mean people can afford to borrow more money, so have more money to spend. This makes the economy grow and inflation increase.

In short, inflation is one of the indicators used to measure economic growth, which can be controlled by interest rates, which in turn affect inflation.

Things to discuss with your adviser

Both inflation and interest rate changes can have dramatic consequences for your investment portfolio. For example, interest rates can influence the effectiveness of some fixed income investments (such as bonds) in providing an income, versus interest received on cash.

It’s also worth discussing how you can limit the negative effect of changes in interest rates and inflation on your investments over the long term.

To understand more about some technical words mentioned in the article, please refer to our glossary.