Inflation & Interest Rates Relationship Explained


Inflation and interest rates are often linked and frequently referenced in macroeconomics. Inflation refers to the rate at which prices for goods and services rise. In the U.S., the interest rate (which is the amount charged by a lender to a borrower) is based on the federal funds rate that is determined by the Federal Reserve. The Federal Reserve System is the central bank of the U.S.; it is sometimes just referred to as the Fed.

The Fed attempts to influence the rate of inflation by setting and adjusting the target for the federal funds rate. This tool enables the Fed to expand or contract the money supply as needed, which influences target employment rates, stable prices, and stable economic growth.

Key Takeaways

  • There is a general tendency for interest rates and the rate of inflation to have an inverse relationship.
  • In the U.S, the Federal Reserve is responsible for implementing the country’s monetary policy, including setting the federal funds rate which influences the interest rates banks charge borrowers.
  • In general, when interest rates are low, the economy grows, and inflation increases.
  • Conversely, when interest rates are high, the economy slows and inflation decreases.

Inverse Correlation Between Interest Rates and Inflation

Under a system of fractional reserve banking, interest rates and inflation tend to be inversely correlated. This relationship forms one of the central tenets of contemporary monetary policy: Central banks manipulate short-term interest rates to affect the rate of inflation in the economy.

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The below chart demonstrates the inverse correlation between interest rates and inflation. In the chart, CPI refers to the Consumer Price Index, a measurement that tracks changes in prices. Changes in the CPI are used to identify periods of inflation and deflation.

In general, as interest rates are reduced, more people are able to borrow more money. The result is that consumers have more money to spend. This causes 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 because returns from savings are higher. With less disposable income being spent, the economy slows and inflation decreases.

To better understand how the relationship between inflation and interest rates works, it’s important to understand the banking system, the quantity theory of money, and the role interest rates play.

The Delicate Dance of Inflation and GDP

Fractional Reserve Banking

There is currently a fractional reserve banking system in place. As a heavily simplified demonstration of the money supply grows, suppose that when someone deposits $100 into the bank, they maintain a claim on that $100. The bank, however, can lend out those dollars based on the reserve ratio set by the central bank. If the reserve ratio is 10%, the bank can lend out the other 90% (which is $90 in this case). A 10% fraction of the money stays in the bank vaults.

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As long as the subsequent $90 loan is outstanding, there are two claims totaling $190 in the economy. In other words, the supply of money has increased from $100 to $190.

Quantity Theory of Money

In economics, the quantity theory of money states that the supply and demand for money determine the rate of inflation. If the money supply grows, prices tend to rise. This is because each individual unit of currency becomes less valuable.

Hyperinflation is an economic term used to describe extreme inflation. In an environment where there is hyperinflation, price increases are rapid and uncontrolled. While central banks generally target an annual inflation rate of around 2% to 3% (this is considered an acceptable rate for a healthy economy), hyperinflation goes well beyond this. Countries that experience hyperinflation sometimes have an inflation rate of 50% or more per month.

Interest Rates, Savings, Loans, and Inflation

The interest rate determines the price of holding or loaning money. Banks pay an interest rate on savings in order to attract depositors. Banks also receive an interest rate for money that is loaned from their deposits.

When interest rates are low, individuals and businesses tend to demand more loans. Each bank loan increases the money supply in a fractional reserve banking system. According to the quantity theory of money, a growing money supply increases inflation. Thus, low interest rates tend to result in more inflation. High interest rates tend to lower inflation.

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While this is a very simplified version of the relationship, it highlights why interest rates and inflation tend to be inversely correlated.

The Federal Open Market Committee

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 target employment rates, stable prices, and stable economic growth. The Fed will raise interest rates to reduce inflation and 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 typically rallies in response to an interest rate increase, while the bond market falls in reaction to rate hikes.

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