What’s the relationship between inflation and interest rates?

Maintaining a steady rate of inflation is a key part of a central bank’s remit, but it’s safe to say it can be a tricky job.

Over the long term, rising inflation is good. It’s a sign that an economy is growing, and provides a compelling reason to invest or spend cash – because any capital that isn’t earning returns will lose value.

But if inflation rises too high – particularly when wages haven’t also increased – then goods can become too expensive. At the extreme end of this you have hyperinflation, which can spiral to make a currency completely worthless.

So most central banks are tasked with maintaining an inflation rate of around 2-3% per year. And what’s the best way of maintaining steady inflation? Interest rates.

How do interest rates affect inflation?

Raising or lowering the base interest rate for an economy should either boost saving or boost spending. Both of those will have a wide range of knock-on effects for the economy, and eventually end up either raising or lowering inflation.

Raising the interest rate

Increasing the base interest rate raises the cost of borrowing for commercial banks. This encourages them to raise their own interest rates, meaning that businesses and consumers will find that saving gets higher returns and borrowing is expensive.

This lowers spending in an economy, causing economic growth to slow. With more cash held in bank accounts and less being spent, money supply tightens and demand for goods drops.

Lower demand for goods should make them cheaper, lowering inflation.

Lowering the interest rate

Lowering the base interest rate drops the cost of borrowing for commercial banks. This encourages them to lower their own interest rates.

Businesses and consumers will then find that interest rates on both savings accounts and loans are low. So borrowing and spending is attractive, but saving is discouraged.

This causes the economy to grow, widening money supply and increasing spending on goods and services. Higher demand for goods should make them more expensive, increasing inflation.

It’s always worth remembering, though, that economics is rarely simple – lots of other factors can come into play when interest rates are raised or lowered. And sometimes, a central bank faces low inflation and can’t lower interest rates. This might be when it considers quantative easing (QE).

Inflation and interest rate expectations

Knowing how central banks use interest rates to affect inflation, it’s simple to work back to how inflation can affect interest rate expectations. When inflation is rising faster than a central bank wants, they might try and combat it with an interest rate hike. If inflation drops below the target rate, they might lower interest rates accordingly.

Taking inflation rates as the sole factor behind interest rate moves can be dangerous, though. Each central bank will have its own policy on inflation, which may change over time. Plus they’ll take lots of other economic factors – like cost of production and raw materials – into account before deciding how to act.

How inflation impacts forex prices

When it comes to the relationship between inflation and forex trading, things get a bit more complicated.

Falling inflation makes the value of a currency rise relative to others. The purchasing power of consumers tends to increase as inflation drops, because they can buy more with the same amount of cash.

Likewise, higher inflation should push a currency down in value.

However, as we’ve seen above, when inflation rises above the target rate set out for an economy, a central bank might respond by raising interest rates. If interest rates are higher in a particular economy, then investments in that economy will yield higher returns – leading to more demand for its currency. When demand increases, prices usually follow.

Say, for instance, the UK inflation rises above the 2% target set by the government. While that might mean that the pound's value is depreciating relative to other currencies, traders could anticipate that the Bank of England (BoE) will raise rates to counteract the rising inflation and start buying sterling. More demand for sterling could then see pairs like GBP/USD go up.

Again, taking inflation in isolation when analysing forex markets isn’t advisable. There are lots of other releases that will sway central bank policy, including employment figures, GDP and wage growth. For a comprehensive list of upcoming announcements, take a look at our economic calendar.