Inflation is the situation in the economy where the prices of every commodity increase at an increasing rate and decline in purchasing power of an individual. It creates a situation where the supply of money increases in the economy due to which the prices are high.

The bank is money regular in the economy who lends money at interest rates. The banks are regulated by the reserve bank of countries such as the Reserve Bank of Australia who fix repo rate, cash reserve ratio, statutory liquidity ratio, the reverse repo rate, and others (Ball, 2017).

During the situation of inflation in economy the role of banks are significant in controlling the present scenario. Monetary policy needs to be applied by the banks where the rate of interest can be increased by the banks which discourage individual to lend money.

It helps to control the flow of money in the economy. Whereas during deflation the money can be increased by the banks by reducing rate of interest which encourage individual to lend money for investment and business growth.

The relationship between banking system and inflation is reverse which helps to stabilize the economy by controlling money demand and supply. In the US, the interest of banks is based on the federal fund rate that is determined by the Federal Reserve.

Once the interest rate goes down by the banks then people start taking a higher loan which increases the money supply in the economy. High-interest rate leads to reduce the disposable income which contracts the money supply in the economy.

The inflation and rate of interest are inversely correlated. The role of central banks is significant in regulating money in the economy (Auer, 2017). It role of the banking system is significant which needs to understand for circulating money in the economy.

Inflation is one of the economic situations where the price of every commodity goes high due to which the price of production also goes high. It increases the cost of product and services which directly which limit the purchases of the buyer. The interest rate and inflation are related to each other strongly. The interest is the cost of money when the money goes lower than the spending increase but the cost of goods becomes relatively cheaper.

• How does Inflation Affect Banking?
• Is Inflation good or bad for Banks?
• What Will Happen If Inflation Goes Up?
• What You Can Do to Beat Inflation in Banking
• How are Interest Rates and Inflation Related?
• Who Benefits from Inflation?
• How does Inflation Affect my Savings?

How does Inflation Affect Banking?

Interest Rate is used to control Inflation by the central banks. Inflation is the continued increase in the general price levels of an economy. On the other hand; interest is the cost of borrowing funds.

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Let us discuss two main situations for Inflation and Interest rates:

Effect of High Inflation on Interest Rates:

To control high inflation: the interest rate is increased.

When the interest rate rises, the cost of borrowing rises. This makes borrowing expensive. Hence borrowing will decline and as such the money supply (i.e the amount of money in circulation) will fall. A fall in the money supply will lead to people having lesser money to spend on goods and services. Hence, they will buy a lesser amount of goods and services.

This, in turn, will lead to a fall in the demand for goods and services. With the supply remaining constant and the demand for goods and services declining; the price of goods and services will fall.

As inflation is a continuous increase in the general price level of goods and services so a fall in the general price level of goods and services will lead to a decline in inflation levels.

Effect of Low Inflation on Interest Rates

In low inflationary situations; the interest rate is reduced. A fall in inflation and interest rates will make borrowing cheaper. Hence, borrowing will increase and the money supply will also increase. With a rise in the money supply, people will have more money to spend on goods and services.

So; the demand for goods and services will increase and with supply remaining constant this leads to a rise in the price level i.e inflation.

Example of Inflation and Interest Rates

On 2 August 2017: RBI reduced the Repo Rate from 6.25% to 6 %(i.e by 0.25%) due to low inflation. India’s consumer inflation declined to 1.54(five year low) for the period: April-September in 2017.

Repo rate is the rate at which commercial banks borrow from RBI. A decline in Repo rate will lead to a fall in the commercial bank’s cost of funding.

In India, all post-April 2016 flexible interest rate loans(including home loans) are tied to a bank’s MCLR. While the pre-April 2016 loans depend on a bank’s base rate. MCLR. MCLR stands for Marginal Cost of Funds based Lending Rate. This reduction in the cost of funding has to lead to many Indian banks reducing their MCLR.

For Example, Bank of India cut its one-year MCLR from 8.4% to 8.3%. IDBI Bank at the same time reduced their one-year MCLR to 8.55% from 8.65%.

This reduction in MCLR will lead to an increase in loan growth in both retail and corporate segment. This, in turn, will lead to an increase in the demand for goods and services as people will now have more money to spend.

This will have a positive impact on the economy. RBI expects that this move will lead to an increase in inflation and Interest rates will automatically get affected.

A very high as well very low inflation can have an adverse impact on an economy. Thus it is necessary to maintain inflation and interest rates at a moderate level because Interest rate plays a vital role in maintaining inflation at a moderate level.

Is Inflation good or bad for Banks?

Prices change from year to year, whether it’s a house, or college, or a loaf of bread. When prices increase over time, it’s called inflation, and the inflation rate is this year-over-year change expressed as a percentage. The U.S. once saw inflation rates as high as 13% in 1978 and as low as 0.1% in 2008; in 2019, it was 1.5% and expected to rise only slightly over the following few years.

Increasing prices result in your money not going as far as it once did. Maybe you could buy four candy bars with a dollar in 1980, but today you could only buy half of one; that’s inflation. It affects interest rates, bank accounts, loans, and other financial activities. Find out what effect inflation may have on your bank accounts and what, if anything, you can do about it.

Inflation vs. Savings Account Interest

When inflation rises, your purchasing power goes down. If inflation outpaces the interest you earn on your bank account, it will feel like losing money. Your balance might be increasing, but not enough to keep up with higher prices.

For example, say you deposit $1,000 in a savings account with a 0.09% annual percentage yield (APY), which was the national average in 2019; after a year, you’d have earned 90 cents in interest. But if the inflation rate is 1.5%, what you could have bought with $1,000 costs $1,015 a year later. You’re effectively behind by $14.10 due to inflation, even though you earned interest.

Although 0.09% is the national average APY, there are still some ways to come close to (or occasionally even beat) inflation; online high-yield savings accounts and some certificates of deposit (CDs) are two places to look.

What Will Happen If Inflation Goes Up?

If inflation heats up in the coming years, you can expect a couple of things to happen: Less purchasing power for the money you’ve saved, and rising interest rates on savings accounts, CDs, and other products.

Loss of Purchasing Power

When you save money for the future, you hope it will be able to buy at least as much as it buys today, but that’s not always the case. During periods of high inflation, it’s reasonable to assume that things will be more expensive next year than they are today—so there’s an incentive to spend your money now instead of saving it.

But you still need to save money and keep cash on hand, even though inflation threatens to erode the value of your savings. You’ll need your monthly spending money in cash, and it’s also a good idea to keep emergency funds in a safe place like a bank or credit union.

Rising Interest Rates

The good news is that interest rates tend to rise during periods of inflation. Your bank might not pay much interest today, but you can expect your APY on savings accounts and CDs to get more attractive if inflation increases.

Savings account and money market account rates should move up fairly quickly as rates rise. Short-term CDs (with terms of six or 12 months, for example) might also adjust. However, long-term CD rates probably won’t budge until it’s clear that inflation has arrived and that rates will remain high for a while.

The question is whether or not those rate increases will be enough to keep pace with inflation. In an ideal world, you’d at least break even; even better if your savings grow more quickly than prices increase. But in reality, rates lag behind inflation, and income tax on the interest you’d earn means you’ll probably lose purchasing power.

Effect of Inflation on Loan Payments

If you’re concerned about inflation, you might get some consolation from knowing that long-term loans could actually get more affordable. If a loan payment of a few hundred dollars feels like a lot of money today, it won’t feel like quite as much in 20 years.

• Long-term loans: Assuming you don’t intend to pay your loans off early, student loans that get paid off over 25 years and 30-year like a fixed-rate mortgage should become easier to handle. Of course, if your income fails to rise with inflation or if your payments increase, you will indeed be worse off. Also, reducing debt is rarely a bad idea because you still pay interest over all those years if you keep the loan in place.
• Variable-rate loans: If the interest rate on your loan changes over time, there’s a chance that your rate will increase during periods of inflation. Variable-rate loans have interest rates that are based on other rates, or benchmarks. A higher rate could result in a higher required monthly payment, so be prepared for a payment shock with these loans if inflation picks up.
• Locking in rates: If you’re planning to borrow soon, but you don’t have firm plans, be aware that interest rates may be higher when you eventually apply for a loan or lock in a rate. If that happens, your payments will be more each month. Leave some wiggle room in your budget if you’re shopping for a high-value item that you’ll buy on credit. To understand how the interest rate affects your monthly payment and interest costs, run some loan calculations with different rates.

Effect of Inflation on Retirement Savings

Another area where inflation can hurt your savings is in your retirement account. After all, if money becomes less valuable over time, a figure that could support your lifestyle comfortably today won’t have the same buying power years from now.

Even if you sock away 15% of your income, as many experts suggest, inflation can eat away at the gains you might make in your 401(k) or IRA. If your retirement accounts gain 6% a year in interest (and they’re certainly not guaranteed to increase in value), an inflation rate of 2% or 3%—plus taxes and fees—can leave your net return well south of that. Properly balancing your portfolio is a strategy used to combat the effects of inflation on your retirement accounts.

What You Can Do to Beat Inflation in Banking

You don’t need to resign yourself to losing out to inflation. There are a few things you can do to try to keep ahead of it (or at least not fall behind).

Keep options open: If you think interest rates will rise soon, it might be best to wait to put cash into long-term CDs. You can use a laddering strategy to avoid locking in at low rates since it’s hard to predict the timing and speed (as well as the direction) of future interest rate changes.

Shop around: A rising rate environment would be a good time to keep an eye out for better deals. Some banks react with higher interest rates more quickly than others. If your bank is slow, it might be worth opening an account elsewhere. Online banks are always a good option for earning competitive savings rates.

But remember that the difference in earnings needs to be significant for you to come out ahead: Switching banks takes time and effort, and your money might not earn any interest while moving between banks. Plus, the bank with the best rate changes constantly—the important thing is that you’re getting a competitive rate.

Changing banks will make the most sense with particularly large account balances or significant differences in interest rates between banks. With a small account or minor rate difference, it’s probably not worth your time.

Long-term savings: Do some planning to make sure you have the right amounts in the right types of accounts. Bank accounts are best for money that you will need or might need in the near-to-medium term, like your emergency fund. If you lose a bit of purchasing power due to inflation, that’s the price you pay for having a liquid source of emergency cash. It’s best to talk with a financial planner to find out what, if anything, you should do with longer-term money.

How are Interest Rates and Inflation Related?

Inflation and interest rates are often linked and frequently referenced in macroeconomics. Inflation refers to the rate at which prices for goods and services rise. In the U.S., the interest rate (which is the amount charged by a lender to a borrower) is based on the federal funds rate that is determined by the Federal Reserve. The Federal Reserve System is the central bank of the U.S.; it is sometimes just referred to as the Fed.

The Fed attempts to influence the rate of inflation by setting and adjusting the target for the federal funds rate. This tool enables the Fed to expand or contract the money supply as needed, which influences target employment rates, stable prices, and stable economic growth.

Inverse Correlation Between Interest Rates and Inflation

Under a system of fractional reserve banking, interest rates and inflation tend to be inversely correlated. This relationship forms one of the central tenets of contemporary monetary policy: Central banks manipulate short-term interest rates to affect the rate of inflation in the economy.

In general, as interest rates are reduced, more people are able to borrow more money. The result is that consumers have more money to spend. This causes the economy to grow and inflation to increase.

The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to save because returns from savings are higher. With less disposable income being spent, the economy slows and inflation decreases.

To better understand how the relationship between inflation and interest rates works, it’s important to understand the banking system, the quantity theory of money, and the role interest rates play.

Fractional Reserve Banking

There is currently a fractional reserve banking system in place. As a heavily simplified demonstration of the money supply grows, suppose that when someone deposits $100 into the bank, they maintain a claim on that $100.

The bank, however, can lend out those dollars based on the reserve ratio set by the central bank. If the reserve ratio is 10%, the bank can lend out the other 90% (which is $90 in this case). A 10% fraction of the money stays in the bank vaults.

As long as the subsequent $90 loan is outstanding, there are two claims totaling $190 in the economy. In other words, the supply of money has increased from $100 to $190.

Quantity Theory of Money

In economics, the quantity theory of money states that the supply and demand for money determine the rate of inflation. If the money supply grows, prices tend to rise. This is because each individual unit of currency becomes less valuable.

Hyperinflation is an economic term used to describe extreme inflation. In an environment where there is hyperinflation, price increases are rapid and uncontrolled. While central banks generally target an annual inflation rate of around 2% to 3% (this is considered an acceptable rate for a healthy economy), hyperinflation goes well beyond this. Countries that experience hyperinflation sometimes have an inflation rate of 50% or more per month.

Interest Rates, Savings, Loans, and Inflation

The interest rate determines the price of holding or loaning money. Banks pay an interest rate on savings in order to attract depositors. Banks also receive an interest rate for money that is loaned from their deposits.

When interest rates are low, individuals and businesses tend to demand more loans. Each bank loan increases the money supply in a fractional reserve banking system. According to the quantity theory of money, a growing money supply increases inflation. Thus, low interest rates tend to result in more inflation. High interest rates tend to lower inflation.

While this is a very simplified version of the relationship, it highlights why interest rates and inflation tend to be inversely correlated.

The Federal Open Market Committee

The Federal Open Market Committee (FOMC) meets eight times each year to review economic and financial conditions and decide on monetary policy. Monetary policy refers to the actions taken that affect the availability and cost of money and credit. At these meetings, short-term interest rate targets are determined.

Using economic indicators such as the Consumer Price Index (CPI) and the Producer Price Indexes (PPI), the Fed will establish interest rate targets intended to keep the economy in balance. By moving interest rate targets up or down, the Fed attempts to achieve target employment rates, stable prices, and stable economic growth. The Fed will raise interest rates to reduce inflation and decrease rates to spur economic growth.

Investors and traders keep a close eye on the FOMC rate decisions. After each of the eight FOMC meetings, an announcement is made regarding the Fed’s decision to increase, decrease, or maintain key interest rates.

Certain markets may move in advance of the anticipated interest rate changes and in response to the actual announcements. For example, the U.S. dollar typically rallies in response to an interest rate increase, while the bond market falls in reaction to rate hikes.

Who Benefits from Inflation?

Many economists agree that the long-term effects of inflation depend on the money supply. In other words, the money supply has a direct, proportional relationship with price levels in the long-term. Thus, if the currency in circulation increases, there is a proportional increase in the price of goods and services.

Aside from printing new money, there are various other factors that can increase the amount of currency in circulation.

Interest rates may be reduced, the reserve ratio for banks may be reduced (the percentage of deposits the bank keeps in cash reserves), there may be increased confidence in the banking system, or a Central Bank may buy government securities or corporate bonds (resulting in people who were holding the bonds having more money to spend), among other factors that may increase the money supply.

Inflation occurs when there is a general increase in the price of goods and services and a fall in purchasing power. Purchasing power is the value of a currency expressed in terms of the number of goods and services that one unit of the currency can purchase.

For example, imagine that tomorrow, every single person’s bank account and their salary doubled. Initially, we might feel twice as rich as we were before, but the prices of goods and services would quickly rise to catch up to this new wage rate.

Before long, inflation would cause the real value of our money to return to its previous levels. Thus, increasing the supply of money increases the price levels. Inflation can benefit either the lender or the borrower, depending on the circumstances.

Inflation Can Help Borrowers

If wages increase with inflation, and if the borrower already owed money before the inflation occurred, the inflation benefits the borrower. This is because the borrower still owes the same amount of money, but now they more money in their paycheck to pay off the debt. This results in less interest for the lender if the borrower uses the extra money to pay off their debt early.

When a business borrows money, the cash it receives now will be paid back with cash it earns later. A basic rule of inflation is that it causes the value of a currency to decline over time. In other words, cash now is worth more than cash in the future. Thus, inflation lets debtors pay lenders back with money that is worth less than it was when they originally borrowed it.

Inflation Can Also Help Lenders

Inflation can help lenders in several ways, especially when it comes to extending new financing. First, higher prices mean that more people want credit to buy big-ticket items, especially if their wages have not increased–this equates to new customers for the lenders. On top of this, the higher prices of those items earn the lender more interest.

For example, if the price of a television increases from $1,500 to $1,600 due to inflation, the lender makes more money because 10% interest on $1,600 is more than 10% interest on $1,500. Plus, the extra $100 and all the extra interest might take more time to pay off, meaning even more profit for the lender.

Second, if prices increase, so does the cost of living. If people are spending more money to live, they have less money to satisfy their obligations (assuming their earnings haven’t increased). This benefits lenders because people need more time to pay off their previous debts, allowing the lender to collect interest for a longer period.

However, the situation could backfire if it results in higher default rates. Default is the failure to repay a debt including interest or principal on a loan. When the cost of living rises, people may be forced to spend more of their wages on nondiscretionary spending, such as rent, mortgage, and utilities. This will leave less of their money for paying off debts and borrowers may be more likely to default on their obligations.

How does Inflation Affect my Savings?

Over time, inflation can reduce the value of your savings, because prices typically go up in the future. This is most noticeable with cash. If you keep $10,000 under your bed, that money may not be able to buy as much 20 years into the future. While you haven’t actually lost money, you end up with a smaller net worth because inflation eats into your purchasing power.

When you keep your money in the bank, you may earn interest, which balances out some of the effects of inflation. When inflation is high, banks typically pay higher interest rates. But once again, your savings may not grow fast enough to completely offset the inflation loss.

How Can It Impact Investments?

The impact of inflation on investments depends on the investment type. For investments with a set annual return, like regular bonds or bank certificates of deposit, inflation can hurt performance — since you earn the same interest payment each year, it can cut into your earnings. If you receive a payment of $100 per year, for instance, that payment would be worth less and less each year given inflation.

For stocks, inflation can have a mixed impact. Inflation is typically high when the economy is strong. Companies may be selling more, which could help their share price. However, companies will also pay more for wages and raw materials, which hurts their value. Whether inflation will help or hurt a stock can depend on the performance of the company behind it.

On the other hand, precious metals like gold historically do well when inflation is high. As the value of the dollar goes down, it costs more dollars to buy the same amount of gold.

Finally, there are some investments that are indexed for inflation risk. They earn more when inflation goes up and less when inflation goes down, so your total earnings are more stable. Some bonds and annuities offer this feature for an additional cost.

How Can You Plan for Inflation?

Inflation is one reason many people don’t put all their money in the bank — over time, that inflation can erode the value of those savings. For that reason, some prefer to keep some of their money in potentially higher-growth investments like stocks or mutual funds, because on average these investments earn more per year than the inflation rate (although they also carry a risk of lower earnings or loss).

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You may also want to consider inflation risk as you figure out what kinds of investments to have in your portfolio. Fixed investments, like bonds or fixed annuities, can be adversely affected by inflation. To diversify, some investors choose to add gold or inflation-indexed investments to their portfolios.

Inflation is a market force that is impossible to completely avoid. But by planning for it and putting a strong investment strategy in place, you might be able to help minimize the impact of inflation on your savings and long-term financial plans.