The relationship between the two is a fascinating one. Normally, an economy's interest rates (on savings) are either equivalent to or higher than the inflation rate. This means savers are not only able to preserve the value of their money, but also grow it.
You're winning if inflation is humming along at 3% and you're earning interest of, say, 6% on a $1,000 investment. On the other hand, if you left your $1,000 under the mattress, at the end of the year you'd discover you only had $970 worth of buying power.
However, because both I's are variables (i.e. not static), there have been times when the relationship between them has not been so orderly. In the early 1970s, New Zealand entered a period of high inflation when the rate of inflation reached upwards of 18% and was at times higher than the after-tax interest rates earned on bank deposits.
That meant that even if you put your $1,000 in the bank, its buying power would have suffered. If money is losing its value, it also means that businesses are less likely to make longterm contracts, discouraging long-term investment in the country's ability to produce goods and services. Another effect of this was to turn investors into borrowers; with inflation outstripping interest rates, it made sense to borrow and put the money into appreciating assets, such as property.
While there are many ways to measure inflation, the main indicator used by the Reserve Bank is the Consumers Price Index (CPI). Published by Statistics New Zealand, the CPI records the change in price of a "basket" of goods and services purchased by an 'average' New Zealander. The percentage change in this basket is usually released quarterly and annually. Since our purchasing habits do evolve over time, the contents of this basket are reviewed and sometimes updated.
Another aspect of the relationship came about in the late 1980s when the Reserve Bank Act was passed. New Zealand pioneered an additional step, which charged our central bank with the task of keeping inflation within a target range specified in the 'Policy Targets Agreement'. This approach has now been adopted in many other economies.
The targets in the Policy Targets Agreement have been periodically revised, but the current Agreement, signed in September 2002, requires inflation to be kept within 1% to 3% per year, on average, over the medium term (this does allow inflation to go outside the band over the short term).
While in the past the Government used a number of tools to keep inflation under control, the Official Cash Rate (OCR),introduced in March 1999, is the main instrument the Reserve Bank uses to control inflation today. And this is where interest rates come into the equation. The OCR is the 'one interest rate to rule them all' because it influences the price of borrowing money in New Zealand. The Reserve Bank reviews the OCR eight times per year and adjusts it as it sees fit to keep inflation within the targets set by the Policy Targets Agreement.
However, a side-effect of our increasingly globalised economy has been that the OCR isn't the only factor influencing the rise or fall of inflation. Market interest rates are also affected by the interest rates available in other parts of the world. A portion of the money that New Zealand banks and financial institutions lend to us is borrowed from overseas, so movements in interest rates offshore can affect interest rates here, even if the OCR hasn't changed.
Another factor contributing to last year's inflation rise was the price of petrol, which is also out of the Reserve Bank's hands. They can however still use interest rates as a tool to manage 'second round effects' such as wage demands and increased business costs.
Generally speaking, higher interest rates keep inflation down, and vice versa. That's because higher interest rates make borrowing less attractive and saving more so! Lower demand for goods and services equals lower prices, which is what we are seeing around the world at the moment. As with anything, there is a delicate balance between the two, and the dance will be sure to continue for years to come.
Read the full Quarterly Investor Focus from ING here.