PennyWorks explains the five ways that inflation is affecting interest rates set by the Federal Reserve.
5 ways inflation impacts interest rates
Higher interest rates
Driven in part by spiraling costs for housing, food, and energy, the Labor Department says the current U.S. rate of inflation is the highest recorded in 40 years. The Federal Reserve has historically increased the federal funds rate to curb high inflation. The federal funds rate reached 20% in 1980, as inflation soared following the 1970s energy shocks.
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Lower interest rates
In historic periods of low inflation, the Fed has decreased the federal funds rate. Following the dot-com bust in the early 2000s, the Fed lowered it to below 1% over fears of potential deflation. “Taking note of the painful experience of Japan, policymakers worried that the United States might sink into deflation and that, as one consequence, the FOMC’s target interest rate might hit its zero lower bound, limiting the scope for further monetary accommodation,” said former Fed Chairman Ben Bernanke in a 2010 speech.
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Consumer loans
When the Fed changes the federal funds rate, that means rates for consumer loans— mortgages, auto loans, credit cards, etc.—go up as well. During periods of high inflation and interest rates, this can impact demand for consumer products as well as homes, cars, and other big-ticket purchases that people finance.
By making buying products on credit or borrowing at higher interest rates less appealing, high inflation can also slow demand and economic growth.
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Savings accounts
Rapid inflation decreases the “real” interest rates earned on savings accounts. This ends up devaluing money stored in banks, which drives capital into financial markets and real estate. Inflation has also driven investors into more volatile or speculative assets, such as cryptocurrencies and non-fungible tokens.
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Impact lag
The Fed often lags behind inflation when setting interest rates. In an attempt to anticipate changes in inflation, the Fed might tweak the federal funds rate before inflation gets out of hand. But thanks to pandemic-fueled government spending 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.
