I learned two things today:
- Inflation is not always a bad thing
- What interest rates are and how they're related to inflation.
In this blog, I'm going to test my newly acquired knowledge by trying to explain it in my own words, exactly like how I would explain it to a non-technical friend.
Disclaimer: Please note that I am not an expert in economics. This blog is written based on my personal understanding and research, which might contain inadvertent gaps or inaccuracies. I encourage you to cross-verify the information where necessary. As always, treat the insights shared here as starting points for your own exploration.
First things first, if you don't know what inflation is, it is essentially a term that is used to describe a state of an economy in which the prices of commodities (e.g., food, oil, groceries) are increasing. It's like when you visit your go-to store and notice that the price of the things that you usually buy have increased compared to the previous year. Depending on where you live, you've probably experienced this already. It's a terrible thing, right? Well, it turns out inflation is not always gloom and doom. In fact, it can actually be considered a sign of a strong and booming economy.
"High prices and a strong economy? What are you talking about?" I get it, anon; I felt the same way. This question came to mind when I came across the following passage while reading John Murphy's book Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications:
Rising commodity prices generally hint at a stronger economy and rising inflationary pressure. Falling commodity prices usually warn that the economy is slowing along with inflation. The direction of interest rates is affected by the trend of commodities. (10)
Murphy doesn't expand on this in the rest of the chapter, and I haven't finished the book, but I don't reckon he does in the rest of the book. Anyway, when you think about it deeply, this statement actually makes sense. Let me try to break it down for you big brain style.
In a booming economy, the employment rate is high and businesses are expanding, and thus, people have more disposable income. This leads to increased demand for goods and services. If the supply of these goods and services can't keep up with the demand, however, prices will go up. This is basic supply and demand: when more people want something that's in limited supply, it becomes more expensive. A little bit of inflation can be a sign of a healthy economy, but too much of it is a problem. It's at this point that central banks may step in and adjust interest rates.
If you're new to the game of borrowing money, an interest rate is essentially the percentage charged on the total amount of money borrowed. For example, if you borrow $100,000 from a bank at an interest rate of 10% per year, you would pay $10,000 per year on that borrowed money. Now, imagine the central bank raises interest rates to 12% to combat rising inflation. Your borrowing costs would increase, and you might think twice about taking out a loan. This is how central banks keep inflation under control. As high inflation starts creeping up, banks begin making borrowing more expensive, thus slowing down spending and investment, which in turn can help keep inflation in check.
There you have it. I've just explained why inflation is not necessarily evil and how central banks utilize interest rates to keep inflation from overheating. I hope you've found this insightful. For a deeper dive into the intricacies of financial markets and the factors that influence them, I recommend reading the rest of the book, which has been an invaluable resource not just in my trading journey, but also in my journey to becoming financially literate.
Reference: Murphy, J. J. (1999). Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications. New York Institute of Finance.