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What is the relationship between inflation and interest rates?


There is a very high correlation between the two. As prices rise, the future value of money declines accordingly. If inflation is running at 3 percent, for example, items that cost $100 today will cost $103 in a year. Someone who buys a one-year bond or bank certificate of deposit, or else a bank that lends money out for that long, will need to receive a 3 percent return just to keep pace with inflation. They will need somewhat more as compensation for the risk that borrowers will default, to cover their costs and to make a return on their investment. For these reasons, debt instruments will be priced so that their interest rates are roughly in line with inflation.

But only roughly. The correlation between inflation and interest rates is not perfect because of the inconvenient fact that the future is unknowable. Interest rates on bonds, bank deposits and loans reflect expectations for the rate of inflation rather than the actual rate. Those expectations are based largely on the current rate, naturally, as well as recent changes in the direction of inflation, but if you can manage to buy bonds or certificates of deposit just before inflation declines or borrow just before it rises, you’ll be doing yourself a favor.

-Conrad de Aenlle