The Relationship Between Interest Rate & Inflation

A visual representation of the movement of interest rates.

There is a strong correlation between interest rates and inflation. Interest rates reflect the cost of money, such as the rate you pay when you borrow money to buy a house or spend on your credit card. Inflation is the cost of things. Most of the time, when inflation increases, so do interest rates. There are several reasons for this.

Inflation

Inflation can be explained in two ways, neither mutually exclusive. One way to think about inflation--the increasing cost of things--is too much money chasing too few goods. In essence, this bids up the price of the goods, inflating their cost. The other way for prices to go up could be that production costs go up. A labor union negotiating a contract for a higher wage, for example, could cause the cost of the product the union members produce to increase, or inflate.

Interest Rates

Generally, interest rates and inflation are strongly related. Since interest is the cost of money, as money costs are lower, spending increases because the cost of goods become relatively cheaper. For example, if you want to buy a home by borrowing $100,000 at 5 percent interest, your monthly payment would be $536.82.But if the interest rate was 10 percent for the same home, your monthly payment would be $877.77.

The Relationship

The home example is a good one, showing the lower the interest rate, the more purchasing power is in the hands of consumers. That is a micro example. On a macroeconomic level, when consumers across the economy spend more money, the economy grows and inflation occurs. Go back to the house example. If numerous people can purchase the same house, the price of the house is likely to increase because there are several prospective buyers. In other words, the cheaper cost of money drives up (inflates) the price of the home. Historically, you can plot the correlation between interest rates and inflation and see that there is a strong positive correlation between the two.

The Sword Can Cut Both Ways

Sometimes you can have too much of a good thing. Imagine wages keep rising, bidding the costs of goods up, and people keep spending more as the interest rates continue to rise. It creates what economists refer to as hyper-inflation, which is not a good thing. It last happened in the 1970s. Eventually, left unchecked, the cost of money would be devalued to practically nothing and the cost of goods would spiral upward.

Putting on the Brakes

The Federal Reserve sets what is called the federal fund target rate, essentially establishing the interest rates banks charge to their most favored customers (usually each other). Since 2008, that rate has floated between zero percent and 0.25 percent. The prime interest rate is determined by a survey of what the top 300 banks charge their favored lenders. If the Federal Reserve determines its target rate is low, it will likely raise the rate to rope in inflation by decreasing the money supply. On the other hand, if the Fed decides the economy is lagging, it is more likely to lower the target rate to spur economic growth by increasing the money supply. If the economy is growing and inflation is in relative check, the target rate usually remains unchanged. As end users, consumers are charged much more than that for various banking and credit products, but it is begins with movements in the prime interest rate.

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