Inflation and interest rates – how are they linked?

How many of us are old enough to remember when salary increases of 7% or 8% per year were normal? Well even if you are, did our standard of living actually improve at a similar rate?

The answer to the second question is ‘almost certainly not’, because in the age where salaries were rising at very high rates, so were prices, and salary increases were largely awarded to maintain living standards rather than improve them. To explain further, a real wage increase is the difference between the nominal increase in pay and the prevailing inflation rate. Therefore a salary increase of 8% awarded at a time when prices were rising at 7% would represent a real wage increase of only 1%. In other words, spending power would increase by just 1% because the remaining salary increase would simply be spent on paying more for the goods and services included within everyday expenditure.

We have become used to reasonably low levels of inflation over recent years but it is worth reminding ourselves that for a long period extending from the 1970s to the mid-1990s, controlling the rate of inflation was the biggest challenge facing governments.

High rates of inflation are a very serious threat to the rate at which an economy can grow, and for a sizeable proportion of the population who are not in work, or are awarded salary increases below the rate of inflation, living standards can fall very sharply.

At its worst, inflation can result in what is known as a ‘wage and price spiral’ where employees demand wage increases that keep pace with inflation which are in turn funded by companies raising their prices, thus ensuring the spiral continues.

After a couple of years in which price increases have been almost been non-existent, inflation has started to increase and by the most widely accepted index now stands at about 3% which is significantly higher than the government target of 2%. In these circumstances policy makers begin to consider what moves might be made to ensure that the horrors described above can be avoided.

The first and most effective method used when fears of rising prices become apparent is for the Bank of England to raise interest rates. The UK economy is largely funded by debt, in other words individuals and companies borrow large amounts of money to spend and invest. The cost of debt is based on the bank base rate set by the Bank of England and as with any commodity, cost will influence demand so an increase in interest rates will reduce the willingness of individuals and companies to borrow money.

Rising inflation is generally a symptom of an economy which is growing faster than is sustainable, so if very low rates of unemployment and/or a shortage of raw materials are accompanied by relatively high levels of economic growth, rising prices are the inevitable consequence. It is at this point that a decision to increase interest rates, by effectively reducing the supply of money, can be used to dampen economic activity and therefore reduce upward pressure on prices.

The Bank of England is now dropping some very heavy hints that after a long period of historically low and stable interest rates, there is now a risk that inflation might settle at a level which is too high for the wellbeing of our economy. We have therefore been warned to expect some interest rate increases over the coming months, a process which is already underway in the United States.

Andy Milsom, Head of Partner Training & Development at BNP Paribas Leasing Solutions

Andy is an experienced sales and finance professional with over 25 years’ experience in sales aid leasing. Andy is widely recognised as an expert in business finance and has in recent years focused his attention on developing partner sales teams develop an understanding of how businesses secure project financing. His training programme – Finance Unlocked – is a highly rated customisable course and is offered at no cost to partners.

If you’re interested in helping your sales team overcome finance-related hurdles during the selling cycle, please get in touch with Andy on 07966 114 243 or email here.