How Do Interest Rates Affect Inflation and Vice Versa?

With prices rising across the board, it’s important to understand the interplay between inflation and interest rates. Members of the public looking to save or borrow for purchases like homes and automobiles are directly affected by this relationship. Investors, businesses, consumers, and policymakers can also benefit greatly by keeping tabs on changing interest rates and inflation. Whether you’re looking to invest, grow your business, secure a loan, or anything in between, it’s important to stay educated on the state of the economy. Learn just how inflation and interest rates intersect to stay on top of your finances in any situation.

What Is an Interest Rate?

Understanding interest rates is more nuanced than it may seem. Interest rates encompass the costs of borrowing money or the return on investment for the lender. They include a percentage of the total amount that is added on top of the principal amount. You’ve likely encountered this with paying interest on car and home loans or earning interest on savings accounts.

Interest rates are set by several different organizations, but the majority of the bank-funded rates in the United States are set by the Federal Reserve. The federal funds rate is the rate at which banks lend to each other overnight. If this is adjusted by the Federal Reserve’s Federal Open Market Committee (FOMC), it has a knock-on effect throughout the economy.

The FOMC meets around every six weeks and determines a target range depending on the state of the economy. For example, financial crises may call for lower interest rates to keep the economy afloat — allowing stable prices so consumers can continue to purchase goods and borrowers can take out loans. Early in August 2024, the federal funds rate was between 5.25% and 5.50%.

The fed funds rate is influenced by the Fed buying and selling government bonds, which takes from or injects money into the economy, respectively. This affects the socioeconomic status of communities, government operations, employment rates, educational institutions, healthcare, real estate, credit cards, and goods and services.

What Is Inflation?

Inflation is more gradual and insidious. The value of money goes down throughout the years, making the perceived price levels of goods and services increase along the way. You’ve likely noticed this when shopping for groceries or filling up a tank of gas, comparing prices to five or 10 years ago and noticing a steep hike.

There are various types of inflation, including:

• Demand-pull inflation is caused by an increase in demand and, therefore, increases the pricing of goods.
• Built-in inflation is based on the expectation of inflation, such as employee wages rising to match the projected inflation of the cost of living.
• Cost-push inflation reflects a rise in the cost of producing goods. This is due to a combination of increased demand, higher-priced raw materials, and higher employee wages.

Inflation differs from deflation and disinflation. Deflation is when prices drop consistently and over a sustained period. It rarely occurs and is worrisome when it does because it can delay spending and cause economic stagnation. Disinflation isn’t as bad as deflation. It is when the inflation rate slows down. Prices are still rising, just not as quickly as projected. This can be a good thing in some cases, like when people are looking to save money while continuing to make purchases. This keeps the economy growing while preventing the general population from struggling.

Inflation occurs due to a variety of factors, including a rise in demand, expectation of higher wages, and supply shocks caused by natural disasters or other unexpected interruptions. Inflation may also occur due to the FOMC miscalculating interest rates.

How Do Interest Rates Affect Inflation?

Interest rates can affect inflation in various ways, including the following situations:

• High interest rates: When the FOMC raises interest rates, it becomes more expensive to borrow money. This, in turn, causes consumers and businesses to dial back their tendency to take out loans for big-ticket items and ramp up their savings. This lowers demand and pauses inflation.
• Low interest rates: When interest rates are low, people and businesses take out more loans and are more likely to invest. This can boost demand and, subsequently, raise prices.
• Carry trade: Higher interest rates may cause a country’s currency to become more attractive to international investors. This can cause exports to be pricier and imports to be cheaper.
• Debt servicing: Higher interest rates cause an increase in the cost of servicing existing debt. This can strain consumer, business, and government budgets, leading to fiscal policy adjustments as well as an inability to keep up with payments.

Remember that interest rates affect inflation in direct and indirect ways, as well as when interest rates are low, high, and in between.

Do Higher Interest Rates Cause Inflation?

It’s a common misconception that higher interest rates cause inflation because it seems intuitive. On the surface, it seems like a tighter money supply from higher rates might reduce spending and demand. In reality, lower demand lowers prices. Interest rates and inflation often move together, but it’s not a straightforward correlation. Rising rates can slow inflation, but other factors like supply shortages and demand shifts also play a large role.

Can Raising Interest Rates Help Inflation?

When the FOMC raises interest rates, it becomes more costly to borrow and spend. This, in turn, reduces demand. Lower demand may equal slower inflation. Historically, this has been effective at times and damaging in others. For example, the beginning of the ‘80s saw a steep increase in the target rate to 14%.

By the end of 1980, the target range rose to its highest ever recorded — 19% to 20%. While this deliberate monetary policy slowed rampant inflation, it led to a deep recession. In short, raising interest rates can temporarily slow inflation but can have long-lasting negative effects on the economy.

How Does Inflation Affect Interest Rates?

Conversely, inflation can also affect interest rates in the following ways:

• Decrease in spending: Higher prices cause lower spending and, effectively, lower demand. This can lower interest rates due to lower demand for credit.
• Strategic investments: Investors and businesses use inflation to predict future pricing and adjust their strategies accordingly. This can cause interest rates to be higher during times of expected inflation.
• Quick-rising inflation: Rising prices often lead to higher interest rates as the FOMC responds.

Similarly, inflation’s effect on interest rates fluctuates and depends on extraneous factors.

Do Interest Rates Rise With Inflation?

The relationship between inflation and interest rates isn’t always predictable or linear. However, interest rates tend to move in the same direction as inflation. Often, interest rates lag behind inflation trends. This means you will see adjustments from the FOMC due to previous economic inflation.

When making financial decisions, for your business or yourself, it’s important to look at several economic factors. From inflation expectations to adjustments by the FOMC, you can more accurately predict a solid return on your investment or the best use of your money, now and for the foreseeable future.