What's the Relationship Between Inflation and Interest Rates?

Inflation and interest rates are linked, and frequently referenced in macroeconomics. Inflation refers to the rate at which prices for goods and services rises. In the United States, interest rates are determined by the Federal Reserve (sometimes called “the Fed”). In general, as interest rates are lowered, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to save as returns are higher. With less disposal income to spend as a result of the increase in savings, the economy slows and inflation decreases.

The Federal Open Market Committee (FOMC) meets eight times each year to review economic and financial conditions and decide on monetary policy. Monetary policy refers to the actions taken that affect the availability and cost of money and credit. At these meetings, short-term interest rate targets are determined. Using economic indicators such as the Consumer Price Index (CPI) and the Producer Price Indexes (PPI), the Fed will establish interest rate targets intended to keep the economy in balance. By moving interest rate targets up or down, the Fed attempts to achieve maximum employment, stable prices and stable economic growth. The Fed will raise interest rates to reduce inflation. Conversely, the Fed will ease (or decrease) rates to spur economic growth.

Investors and traders keep a close eye on the FOMC rate decisions. After each of the eight FOMC meetings, an announcement is made regarding the Fed’s decision to increase, decrease or maintain key interest rates. Certain markets may move in advance of the anticipated interest rate changes and in response to the actual announcements. For example, the U.S. dollar typicallyrallies in response to an interest rate increase.

Source: Investopedia

How do interest rates affect inflation?

• Inflation is the rise over time in the prices of goods and services usually measured as an annual percentage, just like interest rates.

• Inflation is the natural byproduct of a robust, growing economy.
• No inflation or deflation (the lowering of prices), is actually a much worse economic indicator. Also, in a healthy economy, wages rise at the same rate as prices.
• Interest rates is just one factor(but a major driver) affecting the inflation.
• The picture explains the relation between interest rates and economy.

Source: Money, Matter, and More Musings

• There are 2 theories to explain the relation between inflation and economy.
  • Demand-pull theory:
    • Lesser Interest rates will attract lesser savings. So, people tend to spend more when the interest rates are less. Thus creating more demand for goods and services.
    • Lesser Interest rates will encourage people to borrow more money/ So, again people tend to spend more borrowed money when the interest rates are less. Thus creating more demand for goods and services.
    • When supply of goods and services is less than the demand, prices go up. This also results in inflation.
  • Cost-push theory:
    • When the cost of the raw materials and inputs increases, the cost of end products also increases. This rise in cost of goods and services pushes the price higher resulting in higher price.

In a healthy economy, Inflation and Interest rates move hand in hand as shown in graph below and are mutually dependent on each other.

Source: Historical Interest Rates UK
How do interest rates affect the rise & fall of inflation?

• Like we discussed in demand-pull theory, Lower interest rates put more borrowing power in the hands of consumers. And when consumers spend more, the economy grows, naturally creating inflation.
• If the central bank decides that the economy is growing too fast (which is a bad sign in the long term) using indexes like consumer price index (CPI), wholesale price index (WPI), They will try to minimise the effect of it by increasing the interest rates and viceversa.
• This rising interest rates in turn will encourage people to save more and borrow less thus reducing the amount of money in circulation in the market. Lesser money in the market makes it difficult to buy the goods and services thus slowing down the rise in price.
• In short, A stable economy is a healthy economy with right wages and less unemployment.