Get to Know The Connection Between Inflation and Interest Rates

How Are Interest Rates and Inflation Connected?

Inflation and interest rates are closely connected, with interest rate trends closely following inflation trends. In 2012, the U.S. Federal Reserve set an annual target inflation rate of 2%. This inflation rate signifies stable prices, healthy employment rates, and a strong economy. When inflation doesn’t match the target rate, the Fed uses interest rates to bring it back to 2% as part of monetary policy.

When inflation falls below the target rate, the Fed lowers the federal funds rate to help stimulate the economy. The federal funds rate then impacts the interest rate of mortgages, car loans, credit cards, business loans, and many other types of financing. When inflation rises above the target rate, the Fed raises that rate to rein in spending and bring inflation under control. Essentially, interest rates are a tool that the Federal Reserve can use to affect inflation.

Keep reading to learn more about the inflation and interest rates relationship and how it impacts consumers’ personal finances and overall monetary policy. 

What Is Inflation and Why Does It Happen?

Inflation refers to a rise in the price of goods and services. When this happens, money loses purchasing power, so more money is required to purchase the same products. Inflation is measured by both CPI (Consumer Price Index) and PPI (Producer Price Index). 

The CPI measures the price increase to consumers for goods and services, while the PPI measures price increases to producers. When producers have rising costs, they generally pass those expenses on to consumers, so CPI trends often follow closely behind PPI trends. In October 2022, PPI reached an 8% year-over-year increase, while CPI was at 7.7%. 

A variety of political, economic, monetary policy, and environmental factors can drive inflation, but economists generally divide each inflation-driver into two categories: 

Cost-Push Inflation

Cost-push inflation occurs when the supply of an important commodity drops, so the price rises. Shortages affect both consumers and businesses that must raise their own prices to cover the rising cost of producing their goods and services. 

In 2022, multiple factors combined to cause a scarcity of important commodities. The Russo-Ukrainian War decreased the supply of oil worldwide. Because nearly every industry relies on oil for energy, this event caused prices across the board to rise.

Additionally, lingering effects of COVID-19, natural disasters, and shipping accidents caused numerous supply chain issues, leading to shortages of food products, microchips, and lumber, among other commodities businesses rely on to meet consumer needs. Because of these shortages, people noticed the rising cost of electronics, cars, groceries, and many other products.

At the same time, the U.S. faces a shortage of 5.5 million housing units, causing the price of owning and renting to quickly rise. According to the National Association of Realtors, the shortage is so severe it will likely take over a decade to eliminate. 

Demand-Pull Inflation

When demand for goods rises, businesses are able to raise prices because consumers are willing to pay the higher expense. During 2020 and 2021, many consumers decreased spending on travel, dining out, live entertainment, and other costs, allowing them to save money and wait until these things were available again. Additionally, multiple stimulus checks through monetary policy changes allowed Americans to build their savings even more. 

The federal reserve estimated, “U.S. households accumulated about $2.3 trillion in savings in 2020 and through the summer of 2021, above and beyond what they would have saved if income and spending components had grown at recent, pre-pandemic trends.”

Because of this, consumers began 2022 with extra spending money and the desire to participate in activities they had put off, driving up demand for numerous products. 

Additionally, demand for housing in many U.S. cities skyrocketed over the past decade. Between 2010 and 2020, the population of Austin, Texas, grew by 25.84%. Raleigh, Orlando, Phoenix, and many other cities saw their populations grow by more than 15%. The rising demand quickly drove the cost of housing up.

When demand for products rises, businesses expand, creating more job openings. However, if the supply of workers is not high enough to fill all these job openings, businesses must compete for the workers by raising wages, which in turn drives prices up.

NPR’s chief economist correspondent Scott Horsley says the U.S. added 528,000 jobs to the labor market in July 2022, when inflation was at its highest. 

“Just about every industry added workers last month . . . And unemployment fell to just 3.5%, which is tied with the lowest in more than half a century,” Horsely said in August 2022. “Average wages in July were up 5.2% from a year ago.”

What Causes Rising Interest Rates?

The Federal Reserve, the central bank of the United States, controls interest rates. It was created in 1913 to keep the economy stable. Interest rates are one of the Fed’s primary tools for stabilizing the economy. When inflation surpasses the desired level, the Fed raises interest rates to discourage overspending from consumers and businesses. The goal is to temporarily limit the money supply.

What is the Relationship Between Inflation and Interest Rates? 

When the Fed raises interest rates, its goal is to increase the cost of borrowing money enough to decrease consumer and business spending, bringing down inflation through a somewhat limited money supply. But does it always work? Here’s what’s happened in the past when the Fed raised rates:

1970s Stagflation

Inflation began to take off during the 70s after the U.S. stopped backing currency with gold. In 1974, alone, inflation rose from 4.7% to 12.3%. In response, the Fed increased rates from 7% to 11%. But inflation persisted, prompting the Fed to raise rates to 16%. However, these interest rate hikes were causing economic troubles, so the Fed implemented a stop-and-go strategy, meaning they would quickly raise and lower rates hoping to bring inflation down and keep the economy strong. 

This stop-and-go policy led to stagflation. Stagflation is a period of high inflation and high unemployment. High unemployment often leads to lower inflation rates. However, during a period of stagflation, consumers are more likely to be unemployed while quickly losing purchasing power. 

Because of the stop-and-go method of changing interest rates, the Fed’s interest rate choices did not bring inflation down in the 1970s. 

1980s Volcker Shock

When Paul Volcker became chair of the Federal Reserve in 1979, he enacted a monetary policy to end the stagflation of the 70s. When Volcker took office, inflation was above 11%, and unemployment was just below 6%. Volcker quickly raised interest rates as high as 17.6% in 1980, up from an average of 11.1% in 1979. When inflation persisted, Volcker raised rates to an all-time high of 20% in 1981. At the end of Volcker’s tenure, inflation had fallen back down to 3.4%.

While Volcker successfully ended a decade-long period of high inflation, his policies were unpopular with many. His aggressive actions resulted in two recessions, with an unemployment rate of 10.8% in 1982, a higher rate than the peak of the Great Recession. 

1990s Soft Landing

Between 1994 and 1995, the Federal Reserve enacted seven rate hikes, taking interest rates from 3.25% to 6% in just one year. The higher interest rates successfully brought inflation under control without triggering a recession, which is why many refer to this as the Fed’s only “Soft Landing” of economic policy. 

How Does Raising Interest Rates Help Inflation?

As part of its monetary policy, the Fed began raising rates with a small increase in March 2022. April saw a slight decrease in inflation, but in May, rates were back up, higher than they’d been in March. This sparked another increase in May, just before inflation hit a 40-year high in June. 

The Fed responded to skyrocketing inflation with yet another rate hike—this time the highest yet with a 75-point increase. They repeated the 75-point hike in July, September, and November. These hikes seem to be making a difference as inflation is finally trending downward, though still far above the Fed’s target rate.

Issues With Using Interest Rates to Control Inflation

Rapid rate increases can successfully curb inflation, but just as the U.S. experienced during the “Volcker Shock” of the 1980s, aggressive rate hikes can trigger recession and unemployment. 

Current Federal Reserve chair Jay Powell hopes to avoid the economic trouble that came with the rate hikes of the 80s. In an interview with Marketplace, Powell said, “Our goal, of course, is to get inflation back down to 2% without having the economy go into recession.”

While the Fed hopes the economy won’t suffer too much while interest rates rise, Princeton economics professor Alan Blinder says, “It’s going to be very, very difficult. They’re trying to land the plane in very choppy weather, not like we had in the nineties.”

In a September 2022 CNBC survey of fund managers, analysts, and economists, 57% of respondents said the Fed will cause a recession by raising interest rates too quickly, while 26% say the rate changes will only cause a moderate slowdown. 

Chief investment officer at Bleakly Financial Group told CNBC, “I’m fearing they are on the cusp of going overboard with the aggressiveness of their tightening, both in terms of the size of the hikes along with (quantitative tightening) and the speed at which they are doing so.”

Issues With Not Raising Interest Rates Enough

While there are risks related to raising rates too quickly, the Federal Reserve wants to avoid a period of stagflation. To avoid stagflation, it’s critical to raise interest rates enough to truly make a difference. Otherwise, Americans can face a lose-lose situation where workers lose jobs in a struggling economy while inflation continues diminishing their purchasing power. 

While it’s never been seen in the U.S., hyperinflation is another danger that could occur if inflation is left unchecked. Hyperinflation happens when money loses value so quickly that it is nearly impossible to keep up with rising prices. 

In the 1920s, Argentina saw inflation rise above 17%. Over time, the inflation rate quickened, and by the 1980s, it reached nearly 5,000%. Hyperinflation of this type is devastating to an economy and consumers. This is why it’s essential to slow inflation before it snowballs out of control. 

Luckily, experts believe the U.S. has plenty of capability to stop inflation before it ever reaches a point of hyperinflation. VP of AltLine bank Jim Pendergast says, “I don’t think we’ll see inflation stay as low as the Federal Reserve’s inflation outlook of just 2%. That said, I doubt we’ll see the kinds of hyperinflation touted in these apocalyptic article headlines.”

When Will Inflation and Interest Rates Calm Down?

When will inflation go down? Chief economist at Moody’s Analytics Mark Zandi told CNBC in October 2022 that he predicts inflation will begin calming in early 2023. 

“Job growth is starting to throttle back. And then, the next step is to get wage growth moving south, and I think that’s likely by early next year,” Zandi explained. 

Zandi believes a recession can be avoided if his predictions are accurate because the Fed will be able to avoid further rate increases in 2023. 

Senior economist at Pictet Wealth Management Thomas Costerg agrees with Zandi’s timeline for stabilizing interest rates. He says, “I don’t think the Fed will be able to continue hiking past December, as employment is likely to take a sharp turn lower, and that’s likely to be a big red flag for them.”

In the meantime, you can protect yourself from inflation and high-interest rates by: 

• Avoiding taking on any additional debt and paying down debts that you already hold.
• Holding money in high-yield savings accounts and bonds like I bonds and EE bonds. 
• Investing in inflation-hedging investments like real estate and commodity stocks.

To learn more about improving your personal finances, check out these articles:

How to Become Financially Independent 

25 Ways to Make Extra Money