Inflation and Interest Rates

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Mar 17th, 2008 by Kenny

Inflation makes tomorrow’s dollars worth less than today’s. That makes borrowing more attractive to borrowers, but lending less attractive to lenders. In order to compensate, lenders raise interest rates, since (among other things) they too know that the dollars they will be repaid next month are worth less than the ones they loan out today.

So, a vicious cycle is set up. As prices rise, more people (businesses, too) find themselves needing to borrow more if they are to buy the things they want - cars, home improvement, etc. That tends to raise interest rates even further, since there is now more demand for borrowed money. More demand, given a set supply, tends to raise prices. In this case, the price (this is interest paid) is the price of borrowed money.

Since inflation is chiefly caused by governments - whether through high borrowing themselves, or deficit spending, or actual printing of more currency or issuing more credit - there is little an individual can do to change the system. All one can do as a citizen is recognize the causes and advocate sound policies.

But, as a borrower, there is much one can and should do when looking at the situation. After all, governments don’t continually increase inflation - if they did as happened in the late 1970s, for example, interest rates would eventually reach a point where there are loud demands to ‘do something’. When they ‘do something’ it invariably means closing down the spigot, this is reversing or at least slowing the actions listed above.

Those actions have a definite impact on anyone looking to borrow money, just as the inflation did. That deflation may lower rates, encouraging more borrowing, but it also causes dollars borrowed today to be worth less than they would be tomorrow. So you are repaying a loan with dollars that are worth more tomorrow if you held onto them (by saving or investing) than they are today.

So, when you consider borrowing you have to try to make a guess - just as the banks do - about which way inflationary or deflationary pressures are likely to go. That’s a tough job for even professional economists, so how can a laymen be expected to do that with any rationality?

While there’s no sure method, there are some indicators that are available to anyone. It used to be that gold and silver were good indicators, but that is no longer true since the dollar is no longer related to any hard commodity. Still, there are one or two that can be helpful.

Since oil is a very basic commodity that is tied to so much production of other things, as the price of oil rises inflation is likely to heat up some. So look at the price of oil options to see whether prices are expected to be higher or lower in the future.

The price of bond options going up is also an indicator. In this case it suggests that professional money managers are betting interest rates will change sharply over the coming year or two. The relationship is a little complicated and borrowers would do well to consult a specialist.

Just keep in mind that a dollar today is a measure of the cost of goods and services today, just as a dollar tomorrow is a measure of that cost tomorrow. But when borrowing money, you’re buying dollars today to spend today, but will pay them back in the future. How much those dollars are worth when you pay them back is a measure of what that loan will actually cost you.

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