Dr. Monzer Kahf, a prominent economist and counselor states: “First, interest is not a compensation for inflation, and it has never been. Simply, interest is an increment stipulated in a contract of loan provision while inflation happens with time and no one knows, at the time of contract what the inflation is going to be. Interest is a price for lending money or a price for indebtedness, it has nothing to do with inflation and it is contracted whether there is or there is no inflation.

However, whenever people expect inflation they manage their prices so that they cope with their expectations (which obviously may not be true in a sense that actuality would often comes different that what was anticipated). A seller who expect inflation that will affect the cost of new goods he will buy would go ahead and increase the price of the goods he is selling now. Interest lenders do the same. This means that when interest lenders expect a rate of inflation of say 5% they would add this rate to the rate they want to collect as a price for the indebtedness (interest).

Also when there exist risks of default of currency value in terms of other currencies (exchange rates of currencies) lenders will also add a risk premium to the rate they want as interest. In other words, you will notice that in interest lending the charge consists of three components: interest per se, anticipated inflation rate and risks premium. All these three components are put together under one name simply interest because, contractually, they can’t be distinguished from the charge for indebtedness. Of course, when put together they are all together haram.

But if we are able to deal with each one alone. Take the case of risks premium: suppose we have an Islamic non-profit organization such as a waqf as a lender. It gives loans without any price of indebtedness, It is known, indisputably in the Shari’ah that the actual cost of its operation can, and must, be charged to the beneficiaries of its loans (this is well established in classical Shari’ah writings and there is also a resolution to this effect by the OIC Islamic Fiqh Academy) would it be permissible for it to consider the actual losses caused by default, foreign exchange and other mishaps as part of its cost and charge the same to the beneficiaries. The answer is: YES of course.

Now inflation is a little different because you don’t know what it really is! This may sound strange, but can anyone tell me what is the loss of value of currency because of inflation. There is really no way of knowing it exactly. It is estimated by changes in price index. But what is the index, which one we use, consumer prices, producer prices, retail , wholesale, prices calculated by labor unions or by the association of industrialist or by the government, and which department of it, etc. Inflation is felt but can’t be exactly known. This leaves open the idea that any rate you may assign as “compensation for inflation” may include a portion as a price of indebtedness. Thus it is mixed with Riba and can’t really be distinguished although theoretically we talk about it and know what it is! Paradoxical as it is, this treatment of inflation is called indexation. In other words, indexation is assigning a rate that compensates the decline in the value of money.

Because of the way it is calculated and because it is always intermingled with interest, it has become controversial, some people argue it is haram and some other it is halal. One way of solving this problem is by government action. If, after a period of inflation the government decrees that all debts in the society that are affected during this period should be increased by a given rate, this indexation may become permissible and independent from interest.