Inflation, inflation, inflation. This year, rates have been headed up and we keep hearing this word being uttered again and again. Rates have been rising because there is an elevated threat of inflation. The question is – why are these two concepts linked together so often? Today, we would like to reintroduce our simple but hopefully effective explanation.
Suppose you lend someone $100,000 for one year. During that year, the inflation rate rises 10%. When you get paid back at the end of the year, what will your $100,000 be worth? The answer is $90,000 because you can only purchase $90,000 worth of goods with that money. Thus, you would have to charge 10% interest just to break “even.” And banks who lend money are not in business to break even, especially when you figure in the risk of not being paid back.
Thus, the inflation rate becomes the “base” for interest rates. Again, an oversimplification. Next, we must ask whether rising inflation is a threat. For that we look at economic indicators. We just saw a most important indicator – the jobs report. The increase of almost a million jobs last month could be interpreted as a potentially overheating economy. But we must remember that we are still catching up with regard to the number of jobs lost since last year. Overall, the report represents great news – with still a way to go before the economy overheats.