Inflation and interest rates are closely linked. That’s because interest rates are the main means by which central banks in each country control inflation.
Inflation represents a change in price. It officially provides statistics on the Consumer Price Index at the national level (as shown above in the United States and the United Kingdom) and that figure is usually calculated by the government. Governments identify changes in prices by selecting and tracking universal purchases. Such items include, for example, food and beverage, clothing, shoes, transportation, and energy costs.
There are other types of inflation indicators. For example, the producer price index tracks the purchase price of raw materials that manufacturers need to produce their products. In addition, there are indicators such as the housing price index and the energy index.
How are those controls done?
Most central banks have a responsibility to keep inflation below the agreed level (e.g., 2 per cent). When inflation rises, the central bank controls inflation by raising interest rates.
Higher interest rates lead to higher borrowing costs, which in turn reduces spending. This can help keep inflation in check. The opposite holds true. If inflation is low and the pace of economic growth slows excessively, the central bank could cut interest rates to boost borrowing growth and spending expansion.
If that’s inflation, what about “D” and “Stagflation?
Inflation represents a widespread price increase. Deflation is the opposite. So it’s a period of decline in price.
As with inflation, excessive deflation is not desirable. Lower prices can lead to delays in spending and investment, and demand in the economy disappears, weakening growth rates.
Stagflation represents an unusual situation in which inflation and slowing economic growth occur at the same time. This is the situation that many countries could face in 2022.