How Does Inflation Affect Interest Rates?

Inflation and interest rates—two interrelated economic concepts that have become the panic du jour and have Americans second-guessing everything from buying a new car to giving up that guacamole add-on.

What is inflation?

Ever heard your mom say, “I can’t believe a gallon of milk is three dollars; in my day, we paid a nickel!” That’s inflation—the increase in cost of goods and services over time. Several factors cause inflation. The high 8.5% rate we’re experiencing today is primarily the result of labor and product shortages brought on by the pandemic.

What’s an interest rate?

Put simply, an interest rate is the price you pay for borrowing money.

Who sets interest rates?

The Federal Reserve sets the Federal interest rates and adjusts them as a way of promoting a stable U.S. economy. When the Fed rates increase, banks and lenders are nearly forced to do the same in order to keep up with the costs of borrowing money from the Fed.

Who suffers from high interest rates?

Buyers are going to take the hit in times of high interest rates. Taking out a loan (for a car, home, business or otherwise) is going to cost a lot more at 4% interest than 2% and that increase will be reflected in every payment.

Remember that when applying for loans, you’ll often have the choice of a fixed or variable interest rate. As the names suggest, a fixed rate is one that will stay the same over the length of your loan, while a variable rate is one that will change (up and down) over time.

For some borrowers, a variable interest rate will mean a savings in the long run, however, locking in predictable payments with a fixed interest rate provides stability and protection from extreme and unexpected increases like the one we’re experiencing now.

Who benefits from high interest rates?

People who save when interest rates are high can come out swinging. High interest rates can increase gains on savings accounts and provide a buffer against inflation. That said, banks have a strong reputation for moving much slower on increasing the interest rate on money coming in than on money going out (thanks, banks).

So finally, what’s the connection between inflation and interest rates?

In general, inflation and interest rates move in the same direction. In fact, interest rates are the primary tool used by the Fed to manage inflation. In theory, if it costs more for Americans to purchase a loan or keep up with credit card payments, they’ll spend less. This decrease in spending means a decrease in demand, a decrease in prices and eventually a balancing of the economy.

Takeaways

Inflation and interest rates generally rise and fall together. Currently, they’re both high and many Americans can use their grocery and credit card bills to prove it.

But, with knowledge comes power. Understanding that interest rates will continue to rise until inflation falls, we can take better control of our financial wellbeing.

This is a great time to save instead of spend, tackle debt (especially loans with variable interest rates) and budget so you can more comfortably ride out this economic heat wave.

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How Does Inflation Affect Interest Rates?

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