PennyWorks explains the five ways inflation affects interest rates set by the Federal Reserve.
5 Ways Inflation Affects Interest Rates
5 Ways Inflation Affects Interest Rates
As the Federal Reserve raised interest rates by half a percentage point, many Americans are wondering how this move will affect their wallets.
This increase puts the federal funds rate at nearly 1%, up from 0.33%, the highest level since March 2020. The Bureau of Labor Statistics (BLS) announced in May 2022 that consumer prices increased 8.3% for the year ending April 2022. Restaurant and meal-out prices increased nearly 7% from last year, while grocery prices were up 10%, according to the US Department of Agriculture.
The Federal Reserve anticipates that the fed funds rate will reach 1.9% by the end of 2022 and 2.8% by the end of 2023. That may not sound like much, but it can significantly affect consumer spending and borrowing. Fed Chairman Jerome Powell’s goal in raising rates in the largest single increase since 2000 is to fight inflation, but without triggering a recession. There are signs in the cooling housing market and volatility in stock prices that this task will prove difficult. The 30-year mortgage rate is already nearing 5% as home prices cool in several metro areas.
To explain the different ways this will filter into everyday household budgets, PennyWorks has compiled a list of five ways inflation affects interest rates. Data sources include the Federal Reserve, Reuters and The New York Times.
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Higher interest rates
Driven in part by rising housing, food and energy costs, the Labor Department says the current US inflation rate is the highest it has been in 40 years. Historically, the Federal Reserve has raised the fed funds rate to curb high inflation. The fed funds rate reached 20% in 1980, when inflation soared after the energy shocks of the 1970s.
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Lower interest rates
In historical periods of low inflation, the Fed has lowered the fed funds rate. Following the dot-com crash in the early 2000s, the Federal Reserve lowered it below 1% over fears of possible deflation. “Noting Japan’s painful experience, policymakers were concerned that the United States could sink into deflation and that, as a consequence, the FOMC interest rate target could reach its zero lower bound, limiting the scope of further monetary accommodation,” former Fed Chairman Ben Bernanke said in a 2010 speech.
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consumer loans
When the Federal Reserve changes the fed funds rate, that means rates on consumer loans (mortgages, car loans, credit cards, etc.) also go up. During periods of high inflation and interest rates, this can affect demand for consumer products, as well as homes, cars, and other major purchases that people finance.
By making buying products on credit or borrowing at higher interest rates less attractive, high inflation can also slow demand and economic growth.
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Keeping accounts
Rapid inflation reduces the “real” interest rates earned on savings accounts. This ends up devaluing money stored in banks, which drives capital into the financial and real estate markets. Inflation has also driven investors into more volatile or speculative assets, such as cryptocurrencies and non-fungible tokens.
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impact delay
The Federal Reserve often lags behind inflation when setting interest rates. In an attempt to anticipate changes in inflation, the Fed could adjust the fed funds rate before inflation spirals out of control. But thanks to government spending fueled by the pandemic and higher food, fertilizer and animal feed costs from the Russia-Ukraine war, rising prices will persist for months to come.
This story originally appeared on PennyWorks and was produced and distributed in partnership with Stacker Studio.
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