Readers Question: Does low inflation always mean low interest rates?
Yes, Generally low inflation will lead to low interest rates. Although in practise there may be some divergence.
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%
Low Interest rates and High Inflation
There can also be a circumstance when a Central Bank keep interest rates very low, despite an increase in inflation. For example, in 2011, UK inflation reached over 5%, but the Bank of England kept interest rates at 0.5%. The reason for this was.
The Bank of England expected the inflation to be temporary. The inflation was caused by
- temporary one-off increases in VAT (which would not influence inflation rate in 2012)
- Impact of devaluation in value of pound which increases import prices
- Impact of rise in oil prices
Despite the increase in inflation, the Bank of England was also concerned about the threat of the economy sliding into recession. Therefore, they wanted to keep inflation low to boost spending and demand.