Understanding Interest Rates and Inflation

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Inflation causes tomorrow’s dollars worth less than today’s. That makes borrowing more eye-catching to borrowers, but lending less attractive to lenders. In order to counterbalance, lenders increase interest rates, given that (among other things) they too know that the dollars they will be paid back next month are worth less than the ones they loan out today.

So, a vicious cycle is established. As prices go up, more people (businesses, too) find themselves requiring to borrow more if they are to purchase the things they want – cars, home expansion, etc. That inclines to raise interest rates even more, because there is now more demand for borrowed funds. More demand, given a set supply, tends to lift prices. In this event, the price (this is interest paid) is the price of borrowed money.

Since inflation is primarily caused by governments – either through high borrowing themselves, or deficit spending, or actual printing of additional currency or issuing more credit – there is trivial an individual can make to change the structure. All one can do as a citizen is distinguish the causes and urge sound policies.

But, as a borrower, there is a great deal one can and should do when considering the situation. After all, governments don’t constantly increase inflation – if they did as happened in the late 1970s, for instance, interest rates would ultimately reach a point where there are loud calls to ‘do something’. When they ‘do something’ it regularly means shutting down the spigot, this is reversing or at least slowing the events mentioned above.

Those actions have specific effects on anyone looking to borrow money, just as the inflation did. That deflation may lower rates, promoting more borrowing, but it also may result to dollars borrowed today to be worth less than they would be tomorrow. So you are paying back a loan with dollars that are worth more tomorrow if you kept them (by saving or investing) than they are today.

So, when you are thinking borrowing you have to try to make a speculation – just as the banks do – about which way inflationary or deflationary pressures are likely to go. That’s a tough work for even professional economists, so how can typical people be expected to do that with any rationality?

While there’s no sure technique, there are a number of indicators that are available to everyone. It used to be that gold and silver were excellent indicators, but that is no longer true since the dollar is no longer associated to any hard commodity. However, there is one or two that can be useful.

Since oil is an extremely basic commodity that is tied to so much production of other things, as the price of oil climbs up inflation is expected to heat up some. So observe the price of oil options to check whether prices are expected to be higher or lower in the future.

The price of bond options rising is also an indicator. In this case it proposes that professional money managers are betting interest rates will adjust aggressively over the coming year or two. The connection is a little complex and borrowers would do well to seek advice from a specialist.

Just bear in mind that a dollar today is a measurement of the price of goods and services today, just as a dollar tomorrow is a measure of that cost tomorrow. Although, when borrowing money you’re buying dollars today to use today, but will pay them back in the future. How much those dollars are worth when you repay them is a measure of what that loan will essentially cost you.