Interest in Inflation

Inflation and interest rates… Interest rates and inflation.  Anywhere you look or listen these days, you seem to see or hear the same thing.  As such, I thought it might be a good idea to make sure everyone is aware of how inflation and interest rates are related, and why it even matters in the first place.

The biggest single source for determining interest rates in the United States is the Federal Reserve, also known simply as “The Fed.”  The Federal Reserve is the United States’ central banking system, and at its most basic level, has two main objectives: to maintain full employment, and to keep inflation in check.

We can come back to the full employment discussion another day (although it is very much related), and for now, just focus on inflation.  Inflation, just to be clear, is the rate of increase in the price of a good or service, from one year to the next.  For example, if a loaf of bread cost $3.00 last year, and costs $3.30 this year, the annual inflation rate for this item is 10%.  Anyone who has been to the grocery store in the last six months knows that we are seeing some serious inflation right now.   And, it’s been decades since we’ve seen such significant inflation, which is why it is catching everyone so off guard.

When prices for goods and services are rising (i.e., inflating) faster than incomes, these goods and services become less and less affordable to the consumer.  This is known as loss, or erosion, of purchasing power.  And, when U.S. inflation goes beyond where the Federal Reserve would like it to be, which is somewhere around 2% per year, the Fed often steps in to try and slow down the increase in prices.  The main strategy the Fed employs to accomplish this goal is increasing interest rates.  And, when it does so, in theory at least, there are two main inter-related ways that this helps lower the rate of inflation.

First, when interest rates are higher, people are generally more likely to save money and less likely to spend it.  When interest rates are high enough, people are willing to keep money in the bank, instead of buying goods and services, and this lowering of demand for goods and services usually helps to lower inflation.  For example, when bank accounts are paying 0.1% interest or less, as they had been for many years until recently, there is not much incentive to keep money in the bank.  So instead, consumers and businesses are more likely to spend, and less likely to save, and this drives-up inflation.

Next, the higher interest rates go, the more likely consumers and businesses are to forego, or at least delay, a purchase, in order to earn interest on their cash while it is sitting in a bank account.  And, in the same vein, when interest rates are higher, people and businesses are less likely to borrow money to buy more goods and services.  For example, if you can get an auto-loan for 1%, you are much more likely to buy a new car, than if that same loan were to cost you 7% or more.  Or, if you are a business and can borrow money for 1%, you are more likely to borrow to take on new projects, hire new employees, commit to research and development, etc.  This is why there are many people out there right now talking about the likelihood of a general housing-price decline, or, at least, a lowering of the speed of housing price increases.  After all, when you can get a loan to buy a house for 3%, you can afford a whole lot more house than when the same loan costs 7% or more.

At the end of the day, the basic premise is, less money chasing the same goods and services is anti-inflationary.  And, the more money people and businesses keep in savings, and/or, the less they are willing to borrow to buy new goods and services, the more downward pressure on inflation there should be.

Of course, it works in the opposite direction as well.  When the economy hits a rough patch, as it did back in 2008, the Federal Reserve often lowers interest rates, to stimulate spending, which in turn usually drives up inflation.  By lowering interest rates, and thus making savings less attractive, people and business are less likely to save and more likely to spend, which in theory, should stimulate the economy and increase inflation.  And when interest rates are lower, people and businesses are more likely to borrow money to buy more goods and services.

As you can see, the Federal Reserve has a real balancing act on its hands.  Keep interest rates too low for too long, and inflation kicks in and the loss of purchasing power can be devastating.  Or, raise rates too high, and thereby choke off spending, which could easily send the economy into a recession, or even a depression.  What makes this strategy even harder to implement with any real precision, is that the actions the Fed takes now, often don’t show up on the balance sheet for months or even years down the road.  It’s a lot like trying to stop a freight train – it has to be started well in advance, with lots of foresight and correct intuition, and, if not managed correctly, can very easily run right off the rails.


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