What’s the Relationship between Inflation and Interest Rates?

What’s the Relationship between Inflation and Interest Rates?

Reading time: 6 minutes

There is no denying that inflation and interest rates are inextricably connected, influencing one another in a dynamic and often cyclical manner.  

Inflation Defined

We all know that today’s dollar is not worth the same as it was ten years ago as the cost of goods and services has risen. This rise in prices represents inflation: the general increase in prices for goods and services, and is one of the primary concerns for policymakers and economists.

In the US (and most developed economies), the rate of inflation for consumers is most widely gauged using the Consumer Price Index (CPI), a monthly report released by the Bureau of Labor Statistics to assess monthly and year-over-year changes for nominal and underlying inflation (the latter is often referred to as ‘core inflation’). You may also hear the CPI referred to as a ‘cost of living index’.

An economy exhibiting high inflation (rising prices) can lead to a reduction in the purchasing power of many in society, causing an erosion of real income. This can be particularly disconcerting for lower-income families, affected by the increase in prices for food, energy, and, quite often housing. On the other side, deflation (falling prices) signals a stagnating economy. Deflation may also trigger lower consumer spending, which can affect business and employment. The rationale behind this is due to consumers delaying purchases in anticipation of ‘getting a better deal’.

Interest Rates Defined

Individuals borrow money for current consumption or save/invest money for future use. Interest rates (generally defined as a percentage) reflect the cost of borrowing for a borrower, and reward or a required rate of return for a lender. 

The US Federal funds target rate is one of the most important and widely followed interest rates. This is the interest rate that commercial banks lend to one another in the overnight market and affects products offered to consumers, from loans to mortgages. An increase in the Fed funds target rate will tend to see commercial banks increase the interest paid on savings and, by extension, increase the cost of credit for loans and credit cards, while lowering rates has the opposite effect.  

The Connection Between Inflation and Interest Rates

Why inflation and interest rates share a relationship falls on the central bank’s mandate to achieve price stability. 

It is important to be aware that many developed economies work with an inflation target to maintain stable prices (this is usually between 2% to 3%) and helps central banks formulate policy. In an environment where prices are increasing beyond the inflation target, this can prove problematic for businesses regarding future planning and establishing prices, as well as influence consumers’ spending patterns.

One of the primary tools that central banks use to help combat elevated inflation is monetary policy: the adjustment of the overnight interest rate. For the Fed, as highlighted above, this is the Fed Funds target range, for the Bank of England (BoE) it is the Base Rate and for the European Central Bank (ECB) it is the Main Refinancing Operations Rate.

To help fight against inflation, a central bank will increase the interest rate to reduce spending in attempt to control for inflation. In an ideal world, this would discourage aggregate consumption by making the price of credit more expensive. This can also encourage sellers to lower prices to retain customers, thus gradually lowering inflation. There will, of course, be a lag effect as it takes time from the implementation of a change in policy to influence the economy. As a prime example, consumer prices rose considerably on the back of factors such as global supply chain issues during the COVID-19 pandemic. This led to a phase of global policy tightening. Since early 2022, the Fed raised its Fed funds target rate to 5.25%-5.50% from 0.00%-0.25%. But, as of writing, most developed economies are now in a disinflationary phase after reaching their peak inflation rates in late 2022. The annual nominal inflation rate in the US, for example, is now 3.1%.

On the other hand, a central bank may occasionally lower its interest rate to stimulate an economy and encourage spending by dropping the cost of credit. As central banks lower rates, and considering commercial banks price their loans on the back of the central bank’s rate, this can see loans and mortgages being offered at lower rates. As a point of note, commercial banks consider a number of factors to determine their pricing, not just the policy rate set by the central bank. 

A Balancing Act

While raising interest rates is generally considered an effective tool to combat high inflation, it's not without its challenges. Higher interest rates can slow economic growth, potentially leading to job losses and business closures. Conversely, lowering interest rates to stimulate growth can have unintended consequences, such as fuelling asset bubbles and potentially leading to future inflationary pressures if not managed carefully.