How inflation determines interest rates and impacts your household finances

Over the last few days there has been a growing discussion about inflation – not just in India but across the world. The discussion has focused on whether inflation will be back and what that means for economies across the world.

It is, however, important to take a longer perspective on this issue. That is, inflation over a longer period of time has remained more or less stable till the two world wars. Thus, price stability was a feature that was observed for most part of the industrial revolution. The post-war period saw an acceleration in inflation – due to various reasons, and thus, there was a shift in focus towards containing inflation.

Whether inflation returns or not is a separate issue – as is what explains inflation. The important point is that we have a fairly limited understanding of inflationary process and the lack of a rigorous theory to explain movements in prices. Every theory seems to work, for about a decade and then there are revisions, addition of variables etc to get them to work.

But even as we attempt to understand the inflation dynamics, it is important to recognize the importance of inflation in determining interest rates (as central banks tend to use some form of Taylor rule to determine them), and the importance of interest rates in determining individual choices. Interest rates are essentially opportunity costs of holding cash, that is, by holding cash, we forego the rate of interest that could have been earned on the money. Moreover, by holding cash, inflation erodes our purchasing power. Thus, our decision to hold cash or consume is influenced by a series of factors of which interest rates (& by extension inflation) are important factors.

In the context of India, interest rates play a major role as households finance several consumption items. For instance, residential property, automobiles and even consumer durables. These items are readily available through various consumer finance options that allow households to spread their consumption expenditure even if it comes at certain costs (interest costs). Moreover, this allows individuals to use their future income for consumption in present, especially in the case of residential real estate. Thus, it is important to recognize that interest rates do affect sectors such as real estate sector (& automobiles) where low rates can stimulate demand for these assets.

It is further interesting to note that over a longer period of time, we have seen interest rates moderate significantly and while many believe it was because of moderation in inflation, the trend of reduction in inflation has predated the same. The reason for this reduction in interest rates was the sheer lack of investment opportunities which resulted in lower rates for borrowing due to lower demand for the same.
Eventually, post the world-war, the demand for borrowing increased as did inflation which resulted in an increase in interest rates, however, since then globalization has played a major role in capital allocation. However, with limited scope of investments in domestic economies, the trend of capital allocation across borders will continue as investors search for yield but the domestic interest rates are likely to remain low.

The persistent low interest rate regime across the world will allow India to maintain a lower-than-normal rate for a fairly long time. This will first translate into a greater demand for real estate assets, consumer durables etc but will eventually assist in adding fresh capacity in the country in the form of capital formation. One will have to keenly wait for these developments unfold over the next couple of years but India is unlikely to face a capital constraint to fund its growth aspirations in the foreseeable future.

(The writer is an economist and policy-researcher. Views expressed are personal)