Does low inflation always mean low interest rates?

Readers Question: Does low inflation always mean low interest rates?

Yes, Generally low inflation will lead to low interest rates.

The UK has an inflation target of CPI = 2%. Therefore, interest rates are used to achieve this target. If inflation falls to below 2% the MPC will cut rates to maintain economic growth. There is no need for high interest rates when inflationary pressures are low.

For example: If you had an inflation rate of 1% and interest rates of 7%. There is a very high real interest rates (7-1 = 6%) Therefore, this would encourage saving and discourage borrowing and spending. This is likely to cause a recession so Central Banks would avoid it.

Will the Monetary Authorities ever Increase Interest Rates when Inflation is Low?

They might increase interest rates a little if:

• They forecast inflationary pressures will increase in the future
• They want to increase the value of the exchange rate
• They want to encourage saving as opposed to inflation.

However, as a general rule, Central Banks would rarely have interest rates more than 3 % points above the inflation rates. e.g. if inflation is 2%, it is unlikely that interest rates will be much more than 5%