What’s the relationship between inflation and interest rates | IG ZA
Jul 19, South African consumer inflation reached its fastest pace so far this year An interest rate hike would put additional pressure on the economy. Mitchell-Innes, Henry Alexander. Rhodes University; The relationship between interest rates and inflation in South Africa: revisiting Fisher's hypothesis. Dec 13, An inventory-driven recovery in the third quarter topped analysts' estimates and ended the technical recession that blighted the economy.
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.
Connecting the dots between the hike in South Africa's VAT and inflation
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.SA's inflation rate increased to 6.1% in April
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. This might be when it considers quantative easing QE. 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. The current list in South Africa includes bread, maizemeal and rice. This is done to support the poor and protect them against higher prices. The VAT increase has been criticised in some quarters on the basis that it affects poor people disproportionately.
But over and beyond that argument, the biggest challenge is that any increase in indirect taxes affects the price of goods and services. The mechanism has worked well in the recent past. Prior to adopting it, South Africa went through periods of rampant inflation in the s and s. Inflation targeting is designed precisely to do this.
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- What’s the relationship between inflation and interest rates
There is no doubt that the rise in the VAT rate will affect the rate of inflation. It should have because it has a duty to prepare South Africans for what its next steps will be.
South Africa Economic Outlook
With the expected acceleration in inflation due to the increase in VAT, an interest rate increase might indeed be necessary if inflation increases sharply, thus retaining it within the inflation target band. This is the lowest level recorded since January Under normal circumstances, an inflation rate at this level would raise the question of whether there was scope for the central bank to ease monetary policy by dropping interest rates.
But these are not normal circumstances given the VAT increase.
At this rate it will be approaching the upper limit of the inflation target, thus raising questions about a possible interest rate hike.