Link between rising food prices (Inflation) and central banks raising interest rates

As the inflation is increasing with higher pace reaching up to 9-10% even in most of the developed countries, banks are adopting fiscal and monetary measures to reduce inflation and its effects.

• Recently US- Fed has decided to increase interest rates by 75 bps to control inflation by 2%. However, experts said that this step can cause recession in market.

• In economics, inflation is a general increase in the prices of goods and services in an economy.
• When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money.
• Following the proliferation of private banknote currency printed during the American Civil War, the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of redeemable banknotes outstripped the quantity of metal available for their redemption.

How inflation and interest rates are linked?

• In a fast-growing economy, incomes go up quickly and more and more people have the money to buy the existing bunch of goods.
• As more and more money chases the existing set of goods, prices of such goods rise.
• In other words, inflation (which is nothing but the rate of increase in prices) spikes.

How interest rates dominate?

• To contain inflation, a country’s central bank typically increases the interest rates in the economy.
• By doing so, it incentivizes people to spend less and save more because saving becomes more profitable as interest rates go up.
• As more and more people choose to save, money is sucked out of the market and inflation rate moderates.

Impacts on the economy

• When growth contracts or when its growth rate decelerates, people’s incomes also get hit.
• As a result, less and less money is chasing the same quantity of goods.
• These results in either the inflation rate decline.
• In such situations, a central bank cuts down the interest rates so as to incentivise spending and by that route boost economic activity in the economy.
• Lower interest rates imply that it is less profitable to keep one’s money in the bank or any similar saving instrument.
• As a result, more and more money comes into the market, thus boosting growth and inflation.

Risks of altering interest rates

• If the Central bank cuts the interest rate, it may be fuelling retail inflation further.
• It must be remembered that inflation hits the poor the hardest.
• Can cause recession: Economic recession is the phase where economic activity is stagnant, contraction in the business cycle, over-supply of goods compared to its demand, a higher rate of the jobless situation resulted in lower household savings and lower expense.