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Interest Rates and Inflation: What is the connection?

Interest Rates and Inflation: What is the connection?

June 13, 2023

How Inflation Affects Interest Rates

Few topics have garnered more weight in the financial news recently than inflation. You may have noticed that often included in this conversation in the federal government's attempts to bring it down (sometimes up) to the goal, which is 2% annually. You may have wondered, "how are these two connected?" Well, let me do my best to attempt to bridge the gap and bring you up to speed on why these two topics are so vital to the health of the financial world. 

What is Inflation?

First off, inflation. Simply put, it measures how much is needed to purchase the goods and services that we all love to consume. It is measured by looking at the price of the goods and services through time and comparing them, the most common measure for this is the Consumer Price Index (CPI). It is measured by the Bureau of Labor Statistics (BLS) by measuring some 80,000 items as its data points. It uses a survey to determine what items people are buying the most to put into the basket of data points to collect. They also assign a weight to each item as determined by how important they are to consumers. There are other measures for inflation including the Personal Consumption Expenditures (PCE) that is put out by the Bureau of Economic Analysis that has a slightly different method for calculating but you get the picture.

Explaining the Federal Funds Rate

Now, how does the federal adjust interest rates based on inflation? The federal interest rate, also known as the federal funds rate, is the interest rate that banks use to loan/borrow money to one another overnight. "Why do they do this?" Banks are required to keep a minimum amount of money in their reserves so banks that have more than they need will loan it out to other banks temporarily to ensure they stay above the threshold and make a little money in the process. The Federal Reserve sets this rate by looking at economic indicators, including inflation, to gauge which direction they would like to move the needle. Think of the federal funds rate as a valve that can be used to increase or decrease the flow of money (aka inflation) by manipulating how much it costs to borrow money. So how often does the fed change the federal funds rate? The Federal Open Market Committee (FOMC) meets 8 times a year where they have the option to adjust rates, though sometimes they choose not to. 

How the Fed Influences Our Mortgage and Car Loans

When the government increases the federal funds rate, it creates a sort of "bullwhip" effect on other borrowing rates such as mortgages, car loans, and credit card rates as all of these take this as a cue for where to set their rate. By increasing the federal funds rate, it discourages people and businesses from borrowing money as it is more expensive and who wants to pay more than they have to for borrowing money? This tends to lead to less economic activity, i.e. less demand, and for all of us who took macroeconomics at Wells Hall on the lovely campus of Michigan State University know, less demand typical creates too much supply and lower prices.

The Inverse Relationship of Interest Rates

During times of economic recession, the fed tends to decrease interest rates for the opposite reason of increasing economic activity. I always think of things in terms of my life (call me narcissistic). If I were looking to buy a new car, would I be more interested if they were charging 2% on a loan or 8%? While many wish it was that easy to just increase the interest rate and bring down inflation, it is not quite that easy. There are other factors at play that are not always easy to control such as labor market conditions, international trade, and government policies. It also usually takes some time to see inflation ease so it can become quite a test of "guess and check" because like participating in a pie eating contest, going too hard too fast can have detrimental effects.


There you have it. The next time you are at a dinner party and someone brings up inflation, just be sure to let them know the fed needs to decrease the interest rate valve but be sure they don't eat too much of their pie too quickly.