What Is the Relationship Between Inflation and Interest Rates?

Remember paying just $2.50 for a dozen eggs? Or perhaps you’re a homebuyer, watching mortgage rates more than double over about the same period? These two economic forces—prices on the one hand and interest rates on the other—represent a fundamental push-and-pull that shapes the economy and influences our daily lives.

Inflation, or the general increase in prices over time, makes the cost of goods and services—like a carton of eggs—more expensive, eroding the purchasing power of your money. Meanwhile, higher interest rates, which determine the cost of borrowing, can also make loans for large purchases, such as automobiles or homes, more expensive.

Central banks, such as the U.S. Federal Reserve (Fed), often raise interest rates to cool things down when inflation heats up. Increased borrowing costs due to higher rates should lead to decreased spending by consumers and businesses alike, which, in turn, should help moderate the rate of price. By understanding this economic dynamic, you can better manage these financial shifts, whether adjusting your shopping budget or reassessing your investment portfolio.

Understanding Inflation

While technological changes have made items like personal electronics and communications services cheaper over the years, essentials like healthcare, education, and housing costs keep rising. The Fed has focused on maintaining a 2% target inflation rate per year because this level is thought to encourage economic growth while avoiding excessive price increases.

As prices rise, inflation effectively reduces the purchasing power of money because a dollar today just doesn’t buy as much as it did, say, 10 years ago. Economists still debate the exact causes of inflation, but the evidence points to multiple factors, including monetary policy decisions, the demand for new loans, employment and gross domestic product growth, supply chain disruptions, wage growth, and even psychological elements like expectations and consumer confidence.

Measuring Inflation

Economists monitor inflation using various measures:

• Consumer price index (CPI): The CPI is the most commonly used inflation yardstick. The U.S. Bureau of Labor Statistics monitors all manner of goods and services ranging from breakfast cereal to haircuts to college tuition, which they then weigh according to normal spending behaviors before calculating price changes from the preceding period.
• Personal consumption expenditures (PCE) price index: The PCE is the Fed’s preferred inflation gauge. While CPI maintains a static basket of goods and services for measurement purposes, PCE adapts its contents based on consumer substitution patterns when prices rise. The PCE rate, therefore, usually tracks below the CPI’s readings.
• Producer price index (PPI): In contrast to CPI, PPI measures price changes from the seller’s perspective. Higher costs for manufacturers and wholesalers usually lead to eventual increases in consumer prices. As such, the PPI functions as a sort of precursor for potential consumer inflation.
• Core Inflation: Core versions of CPI and PCE exclude food and energy prices, which move less predictably because of weather conditions, geopolitical events, and seasonal changes. The Federal Reserve generally means core PCE when they discuss “underlying inflation.”

How Interest Rates Affect Inflation

Interest rates essentially represent the cost of borrowing money, expressed as a percentage of the amount borrowed. For example, if you need to borrow $1,000 for two years and the interest rate is 5%, you’d have to pay $50 per year (or $100 total). If interest rates rise to, say, 7%, your yearly interest charge will increase to $70 ($140 total).

Higher interest rates naturally lead to decreased demand for borrowing money, which, in turn, slows the pace of inflation by reducing overall demand and mitigating upward pressure on prices.

The initial response from consumers to rising interest rates is often a decreased willingness to finance major purchases such as homes, vehicles, and household appliances. At 3% mortgage rates, a family might be able to afford monthly payments for a $300,000 home, but 6% could make the same property unaffordable. When borrowing costs increase, businesses, too, tend to delay their growth plans and reduce capital expenditures, which can result in job losses and lower wage growth.

The increase in interest rates also makes servicing variable-rate debts (such as credit cards and ARMs) more costly for households, forcing many Americans to cut spending on other things further to afford the higher interest payments.

Alternatively, when the economy is experiencing a downturn or recession, and inflation is perceived to be low, the Fed may lower interest rates, increasing the supply of money available to borrow at a lower cost, hoping to stimulate the economy, resulting in higher inflation.

Inflation Targeting and the Fed Funds Rate

Inflation targeting is a monetary policy mandate where a central bank, such as the Federal Reserve, publicly sets an explicit target for the annual inflation rate.

In 1996, Fed Chair Alan Greenspan faced a thorny question posed by then-Fed Governor Janet Yellen (who later became Fed chair as well): She asked, “How much inflation is acceptable?” After considerable debate, Greenspan and his colleagues quietly settled on 2% as the magic number—though they wouldn’t publicly acknowledge this target for years. This inflation target, while somewhat arbitrary in hindsight, was chosen because research suggested that a small, positive amount of inflation greases the wheels of commerce without eroding purchasing power too severely. Zero inflation might sound ideal, but it would leave no buffer against deflation—price decreases that could be a potentially more destructive force to the economy as consumers delay purchases, waiting for ever-lower prices.

Today, the 2% inflation target remains the guiding star of many nations’ monetary policies.

The Fed’s primary tool for hitting this 2% target is the federal funds rate (or “fed funds rate”)—the interest rate banks charge each other for overnight loans (because some banks end the business day with too little in reserves, while other banks have idle, excess reserves). While ordinary people don’t directly borrow at this rate, it forms the foundation of the entire interest rate ecosystem.

When the Fed adjusts the fed funds rate, the effects cascade through the rest of the economy:

1. Banks immediately adjust their prime lending rates.
2. Credit card companies update their adjustable percentage rates (usually within a billing cycle).
3. New auto loans and adjustable-rate mortgages become more or less expensive as they are set a certain number of basis points above the overnight rate.
4. Bond markets re-price fixed-income securities as newly issued bonds will reflect the new rates.
5. Businesses reassess expansion plans based on new borrowing costs.

Issues With Using Interest Rates to Control Inflation

Interest rates still remain central banks’ primary inflation-fighting tool, but this approach comes with significant limitations that can frustrate policymakers and create unintended consequences throughout the economy.

The full impact of changes to the Fed Funds rate takes time to spread throughout the economy. The lag between interest rate changes and their economic effects requires policymakers to project future inflation trends when they set current interest rates. But central banks can only rely on past inflation data. Former Fed Chair Ben Bernanke compared this challenge to driving while looking only in the rearview mirror.

Second, the impact of interest rate adjustments varies across different economic sectors. Monetary tightening usually impacts rate-sensitive industries such as housing and auto manufacturing the most but leaves other sectors less affected. The Fed’s 2022 to 2023 tightening cycle, for instance, caused a sharp decline in housing market transactions while inflation in the service sector stayed persistently high.

Interest rates function by regulating demand which limits their effectiveness in situations of supply-driven inflation. Higher interest rates fail to address inflation issues originating from, say, pandemic-induced supply chain breakdowns or energy shocks—it’s not like the Federal Reserve can boost semiconductor chip production or oil output directly in any way.

The Bottom Line

Monetary policy decisions depend fundamentally on the complex interaction between inflation and interest rates, which influences individuals, businesses, and financial markets. Central banks increase interest rates to combat rising inflation, slow down economic activity, and decrease overall demand while reversing course during economic downturns. Thus, the connection between the two is critical not just for macroeconomic analysis but also for everyday spending.