BRIEF: INFLATION AND INTEREST RATE

Inflation is a sustained increase in general price level, and as a consequence, it reduces the purchasing power of money. Inflation is commonly measured using the Consumer Price Index (CPI), which tracks the mean changes in prices of selected basket of goods and services within a specified period. In preliminary economics, inflation is considered a risk, just as it is considered a cost to businesses. Inflation erodes the value of a currency. In an economy or business environment where the rate of inflation continues to rise, that would mean the value of money today is worth more than it would be in the future.

Three things could potentially happen in consumer behaviour response to inflation; one is that, consumers would prefer to spend the money today to avoid spending more on a later date than they would ordinarily spend for the same basket of goods and services. Consumers can choose to save, and they can also decide to invest. On savings and investments, the attraction would be the savings rate or the returns on a planned investment, which determines whether they would defer spending and part away with a sum of money for savings or for investment purposes; or spend today to avoid the future burden. Note that, interest rate is referred to as the price for money. This means consumers would respond to savings or investments when the rate that accrue to their action is higher than the rate of inflation. 

Is inflation really bad? Well, not outrightly. Some level of inflation is reasonable. Just as deflation is not necessarily a good thing for the economy, even though consumers would prefer to purchase items at a cheap price or even prefer to take items for free. What is actually good is a stable price, which is the primary responsibility of Central Banks, amongst other institutional mandates.  Deflation is equally as bad for the economy as high inflation rate is, or having a worse scenario such as as hyperinflation or stagflation. Example of a country faced with deflationary pressure is Japan and the struggle with the issue of liquidity trap. (I could write about this in the coming days). 

Typically, Central banks across the world have what is known as inflation target, that is, the rate of inflation they consider permissible for the economy. In the United Kingdom and the United States of America, inflation target is pegged at 2%. A deviation from this target could cause the Bank to become dovish or hawkish with respect to change in its short-term interest rate or what is also known as Monetary Policy Rate (MPR) or known in the United States as Federal Funds Rate. Although in Nigeria, the central bank has a single-digit inflation target, what remains unclear is whether it is 9%, 5% or 1%.

Note that the Bank's inflation target is the core inflation rate and not the headline inflation rate, which is the general price increases excluding changes in food and fuel or gas prices; this is because of the volatility in the food and oil sector. (The headline inflation however captures everything). The Bank targets the core inflation so they can adjust the rate of interest in response to change in inflation rate, and not just any sudden increase in prices that could be driven by change in food or gas prices. 

Even though the Central Bank links inflation to increase in money supply (hence, the adjustment of short-term interest rate, which determines the cost of loanable funds), drawn from the assertion of Milton Friedman that inflation is always and anywhere a monetary phenomenon, and that inflation is too much money chasing too few goods. It is essential to know that inflation has different sources. It could be caused by increase in demand (demand-pull inflation), increase in the cost of production (cost-push inflation), increase in wage rate (wage inflation), increase in price of assets or commodity or even change in exchange rate.

The Central Bank will always use interest rate as a tool to control for excess liquidity in the system or to lower constraint on liquidity by reducing interest rate, reserve requirements or increasing loan-deposit requirement etc. The Bank can also purchase or sell treasury instruments (an action classified as Open Market Operation). Today, we have also seen Central Banks in advanced nations employ the use of Quantitative Easing to release liquidity into the financial system as a means to address some of the economic problems that the novel coronavirus pandemic portends for the economy. 

Understanding the different sources of inflation should help in the direction of policy actions in controlling the rate of inflation. It should also be appreciated that there is a general consensus that inflation is closely linked to money supply, but when the cause of inflation is outside what the monetary policy tools of the Central Bank can deal with, as in the case of wage inflation (wage rate or minimum living wages are fixed by the fiscal authority), it is best to approach it from its source, rather than adopting the pull and push adjustments of rates.