Inflation and interest rates, why do they matter to lawyers?

Introduction

The words inflation and interest rates may usually not be immediately connected to lawyers and their areas of expertise, but for those involved in corporate or commercial work and contracts these macroeconomic terms and forces are a reality. When hearing these terms you may think of news headlines about the pandemic, rising prices, mortgage rates and the cost of living crisis, yet they go beyond this and create legal risks, influence the performance of companies and influence negotiations. 

What do these terms actually mean?

• Inflation - broadly it is the rate at which general price levels rise in an economy, meaning the purchasing power of money falls. This can be understood as when inflation is high, the single units of currency are able to buy less goods and services than prior. On the other hand, when inflation is lower the purchasing power of the currency units increase. [1]

• Hyperinflation - this term refers to the instances when money is printed by the government to fund or pay off excessive spending and debts. This leads to a rapid increase in the money supply which outweighs and isn’t supported by economic growth, meaning there is a fast depreciation in the value of the currency, so prices skyrocket and a vicious cycle is created, with the population leaning to rapid spending as confidence is lost in the currency [2]. Some of the most famous hyperinflations in history were in the Weimar Republic in Germany 1922 and 1923 post WW1 [3] and in Zimbabwe during 2007 to 2009 [4].

• Interest rates - this can be explained as the cost of borrowing money or also the return for saving. They are heavily influenced by central banks and their policies and are used as a tool to control inflation and economic growth [5]. 

The Fisher Effect:

The Fisher effect is a key theoretical link that suggests that the nominal interest rate will move up in accordance with the expected inflation rate. What this means in practice is that when inflation begins to rise, central banks will often look to raise interest rates too in an attempt to reduce inflation, as this makes borrowing money more expensive so demand is slowed down [6]. 

How These Macroeconomic Shifts Impact Legal Work:

• Fixed-price contracts - There is an inflation risk when a business signs and enters a contractual agreement with fixed payment terms over a long period of time. Examples of this could be a supply agreement, a lease or a construction contract, where high inflation can erode the value of money for either party, the supplier or buyer. This means that these types of contracts can become less favourable if inflation surges past what was anticipated [7]. From a legal perspective, these risks can be mitigated by taking reasonable steps prior to entering an agreement by including adjustment clauses or renegotiation mechanisms, as well as the consideration of whether the contract remains viable after such a change in the economic conditions.

• Borrowing costs and debt - Individuals and companies can face issues when interest rates go up. When interest rates do go up, companies with variable rate debt or those that need refinance may suffer higher repayments. This was evident when the Bank of England noted that when the interest rates were higher, the cost of debt servicing was raised for businesses which in turn increased default risk [8]. 

• Contract performance under inflation - When the economy suffers inflation this can lead to an increase in input costs, labour costs and supply disruptions which would all affect the performance of a contract and the terms agreed. This can be a risk to a business as they may need to increase their expenditure to meet the contractual terms [9]. A lawyer must consider whether a contract is becoming unworkable under the new economic conditions, whether a force-majeure clause applies or other forms of mitigation. 

The Impact of Geopolitics:

• Covid-19 Lockdowns - This event didn’t just freeze daily life, it initiated one of the most significant and turbulent economic distortions in decades. Due to the health restrictions and quarantine, factories closed, shipping routes were affected and labour shortages were suffered across many sectors, this was a global crisis. At the same time, due to millions of people being stuck inside, consumer demand began to surge in areas such as electronics, home goods and appliances, all through online retail, this prompted governments to inject stimulus money into the economy, leading to prices starting to increase. Supply chains were largely affected and took time to recuperate, inflation rose and this led to central banks globally to raise interest rates to reduce the demand [10]. 

• Trump’s Tariffs - The recent tariff increases announced by Donald Trump on a wide range of Chinese imports represent a clear example on how geopolitics can reshape market conditions. Tariffs function like a tax on goods entering the country, meaning that companies either absorb the cost by paying it or pass it to the consumers by increasing the retail price of the items. Previously, the tariffs on Chinese goods entering the US have contributed to higher input prices for American businesses, especially in sectors such as technology, manufacturing and retail. However, this new wave of tariffs can increase the operating cost of businesses, which can feed an inflationary pressure. The markets also tend to interpret tariff increases as a risk, which can have a negative effect in the form of uncertainty, influencing central bank policies [11].

Final Thoughts:

In a world where macroeconomic shifts and changes can occur faster than before, lawyers involved in commercial matters must have an understanding of inflation and interest rates. These terms can have a serious impact on contract terms, corporate health, risk allocation and the very basis and viability of business promises and agreements. By understanding these terms and consequences, lawyers can be better positioned to advise clients in a proactive manner, not reactively.