Inflation and interest rates are two essential parts of the modern economy. Inflation measures how quickly prices increase over time, while interest rates are the cost of borrowing money.
Inflation and interest rates tend to move in the same direction. When inflation is high, interest rates usually are, too, and vice versa. Understanding the relationship between interest rate and inflation can help you make better financial decisions.
What is an interest rate?
At its most basic, an interest rate is the cost to borrow money. When you borrow, the lender can't invest or spend the money while you have it. Lenders charge interest to make up for this. When you borrow, you must pay back more than you received for the interest.
For example, you take out a $10,000 personal loan with a 10% interest rate. You must repay the original $10,000 loan with another $1,000 of interest (10% x $10,000.). Altogether, you owe $11,000 because of the interest cost. Different types of interest rates impact how much you owe for borrowing.
When interest rates are high, it costs more to borrow. When rates are low, it costs less to borrow. You can also earn interest through bank deposit accounts, like a savings account or certificate of deposit (CD). When interest rates are high, you earn more. When rates are low, you earn less.
Interest rate trends
Interest rates go up and down over time, depending on the state of the economy. When the economy is strong, rates usually go up. That's because more people want to borrow to buy homes, spend on credit cards, and start businesses. When the economy is weaker, people spend less, and rates tend to fall.
The Federal Reserve also impacts interest rates. "The Fed" is the central bank of the U.S. and is in charge of setting policies for banks. The Federal Reserve sets a baseline rate for overnight loans between banks. Bank interest rates go up and down in the same direction as the Fed rate.
What is inflation and how is it measured?
Inflation shows the overall increase in the price of goods and services over time. Historically, prices go up over time. That's why, 100 years ago, you could've bought a movie ticket for 15 cents and a house for around $6,000.1 A dollar in the future buys less than a dollar today because of inflation and rising prices.
The Federal Reserve measures inflation in the United States. It tracks everyday consumer expenses like:
food,
clothing,
housing,
vehicles,
and healthcare.
The Fed compares the average cost of these categories over time to measure the rate of change for price increases.
Inflation tends to be higher when the economy is strong. At this point, more people and businesses are spending, which pushes prices up. When the economy is weak, inflation tends to be lower. When the economy is in pretty bad shape and people are losing jobs, prices can fall, which is known as deflation.
The Federal Reserve's mission is to keep the economy growing while ensuring inflation doesn't get too high. If inflation is too high, it's a major nuisance because prices keep changing and going up. The Federal Reserve aims to keep inflation at 2% a year.2
Inflation generally refers to prices in the entire economy. You might also hear the term lifestyle inflation, which is when your spending increases as your income increases, so you don't save money.
How do changes in interest rates affect inflation?
The Fed uses interest rates to control inflation. But how does raising interest rates affect inflation?
When interest rates go up, people borrow and spend less. This helps cool off the economy, which slows down the rise in prices and inflation. When interest rates go down, it encourages people and businesses to spend more, boosting the economy and potentially increasing inflation.
Generally, interest rates are high when inflation is high because the Fed raises rates to slow down rising prices. Interest rates are usually low when inflation is low, as the Fed is trying to boost the economy.
Historic example
In January 2022, the Fed set its interest rate target very low, between 0% and 0.25%.3 It kept rates low because it was worried about the economy's recovery from COVID-19 shutdowns. However, the economy started overheating, and inflation skyrocketed to the highest it had been since the 1980s.4 People felt frustrated with the rising cost of food, travel, and household goods.
In response, the Fed increased its target interest rate until it reached between 5.25% and 5.50% in July 2023.3 The cost of car loans, mortgages, credit card rates, and other sources of borrowing became much more expensive. As a result, people and businesses slowed down their spending. This helped cool off the economy and brought inflation back down to the target. In other words, prices stopped growing as fast.
The Fed can cut interest rates to boost growth when the economy runs into trouble again. It's a balancing act with planning interest rates and inflation.
Tips for managing interest rates and inflation
So, now that you understand the interest rate and inflation relationship, what does it mean for your money and financial plan? Here are some general guidelines for different conditions.
When there are high interest rates
Avoid borrowing whenever possible: High interest rates make borrowing more expensive. Do what you can to pay your credit cards and avoid other sources of debt, like personal loans. You might still need to borrow for major purchases like a car or home.
Try to pay more upfront as a down payment so you take on less debt at high rates. And keep an eye on market conditions. If rates fall after you take out these loans, you could refinance at a lower cost.
Use deposit accounts paying high rates: When inflation is high, it steadily wipes out the value of cash. For example, if inflation is 5%, $1 today will only have the buying power of 95 cents a year from now.
Fortunately, banks typically pay more when interest rates and inflation are high. Look for a high-yield savings account to grow your money along with inflation. The right bank can help you save when inflation is up.
If you don't need immediate access to your money, you could use a CD to lock in a high interest rate for years. That way, you can keep earning lots of interest even after rates fall in the future.
Consider investments that protect against inflation: Some investments perform better during high inflation. Some of the best investments for inflation include gold, real estate, commodities, and Treasury Inflation-Protected Securities (TIPS). You could also buy long-term bonds when interest rates are high. Once again, it's a chance to lock in these rates for an extended period.
During times of low interest rates
Take advantage of long-term loans: When rates are low, it's an ideal time to take out a larger loan, like to buy a car or a home or to start a new small business. If you use a fixed-rate loan, the monthly payments will not go up, even if market interest rates go up later. If you took out past debts when rates were higher, you could refinance now to reduce your monthly payment.
Avoid locking up your cash at low rates: The downside of low interest rates is that you don't earn much with your savings account. Avoid locking up your money at a low rate, like in a bond or CD. Rates will go up eventually. You want to keep access to your cash so you can invest when the time is right.
Prepare for a market rebound: During periods of low rates and inflation, the economy and stock market are usually struggling. As a result, investment prices have usually fallen. While investing during down markets can feel scary, it's a chance to buy stocks and mutual funds at a discount. You can get in when costs are low to benefit when the economy rebounds.
These are just general guidelines for both situations. The right approach for your portfolio and financial plan will depend on your unique circumstances. Consider reviewing your options with a financial advisor before making any significant decisions.
Navigating changing economic conditions
The economy never stands still, so factors like inflation and interest rates also keep changing. As a regular consumer, you don't need to study this information daily like Wall Street professionals or government economists. But it still helps to keep an eye on long-term trends.
Now that you understand the relationship between inflation and interest rates, you can better appreciate what's happening when these are discussed in financial news. And more importantly, how you can adjust your borrowing, bank accounts, and investments in response to new conditions.
Inflation is a challenging economic condition you can manage with the right planning. Use these strategies to grow your income during high inflation.