We hear it on the news daily right now, the Bank of Canada is raising interest rates in an effort to reduce inflation. What does this mean, and what is the relationship between interest rates and inflation? This involves some very complicated and high-level economic theory, but I will try to explain a simplified explanation.

INFLATION

During times of spending, or what the economists would call “excess spending”, consumers have extra cash and a feeling of comfort with spending more money. As we live in a supply and demand economy, the demand goes up, and supply goes down. This puts pressure on prices as suppliers see opportunity to raise prices and scarcity also leads to higher prices due to competition in the marketplace. Due to COVID, we are also experiencing an unprecedented time of undersupply of many types of goods. This causes inflation, or an increase in prices. As costs spiral up, the concern is they may go up too quickly, and people will eventually not be able to afford basic necessities of life, and then we enter into a period of recession.

HOW DOES INCREASING INTEREST RATES AFFECT INFLATION…

As the governments see prices rising, and demand rising, they need to slow down the process, and by reducing buying power, the system slows down. By increasing interest rates, the cost of credit goes up, and consumers feel less comfortable borrowing money. As well, they may decide to invest in interest bearing accounts instead of spending their money. This slows down consumer demand, increasing supply, and thus slowing the process of inflation. This has an effect of stabilizing the economy – sort of cooling off an economy that is a bit overheated, so to speak.

The latest 1% interest hike by the Bank of Canada is an attempt to be one step ahead of inflation. There will be more increases, but we are unlikely to see another one of this magnitude. For more information about how to weather these latest interest rate trends, feel free to contact me for a no obligation consult.