Saturday, 15 December 2007

Interest Rates and Inflation

While interest rates around the world are falling, in South Africa we are faced with rising interest rates. The reason? Inflation.
The inflation is driven by oil and food prices. An international phenomenon. Not by demand.

Higher interest rates cool down the economy and leads to a slow down in demand. That will in theory lead to lower inflation. At least if the inflation is of the demand-push type.

In a nutshell, demand push inflation works like this. Demand for goods and services exceeds the supply or the capacity of the economy so prices go up.

For some time I have been wondering about the inflationary effects of interest. With low rates the effect can be negligable. But what happens when the prime lending rate reaches 14.5% or beyond? Many business rely on large amounts of credit to fund their operations. The interest on this credit represents a major cost to the business. What happens to that additional cost? The only thing that a business can do is to pass the cost onto the customer in the form of higher prices.

So while interest rates may be effective in curbing inflation under some circumstances and within an interest rate range - say 2 to 6 % - when the rate of interest becomes a significant cost, the effect is to fuel inflation more.

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