Inflation and interest rates often move together because the Federal Reserve uses interest rates to control inflation. The Fed has continued to reiterate its 2% annual inflation target, in a bid to maintain price stability and stimulate the economy. Raising benchmark interest rates allows the Fed to reduce inflation, but can carry some economic risks.
In August 2020, the Federal Reserve adopted an average inflation-targeting approach to keep inflation above 2%. Despite signs that central banks might end their tightening policies by year-end, analysts predict consumers will continue to bear the brunt of inflation and high-interest rates into 2024 and beyond. The expected shift to the Federal Reserve cutting rates may come too little, too late, with a recession a possibility (or a probability) depending on which expert you talk to.
Let’s discuss how these rising costs and soaring interest rates are creating the perfect storm requiring financial survivalism.
Understanding Interest Rates, Inflation and Recession
Inflation refers to the increase in the prices of goods and services in the economy. In July 2022, the U.S. had an 8.5% inflation rate, according to the Consumer Price Index (CPI). That means prices increased an average of 8.5% across the board year-over-year. Those cost surges impacting various goods and services, were due to a myriad of factors, including the Ukraine conflict and supply chain shortages, reflecting a supply-demand imbalance.
The Federal Reserve’s main role is to manage inflation and unemployment through the federal funds rate. When it raises this rate, it increases borrowing costs for consumers, making big purchases like homes and cars more expensive.
An interest rate hike can also lead to increased credit card APRs, resulting in higher charges for those with revolving debt.
Interest Rate Hikes Are a Global Phenomenon
The Covid-19 pandemic marked the end of the near-zero interest rate era in March last year. High inflation, supply chain issues and global conflicts led central banks, including the Fed, to raise interest rates to tackle rising costs. The Fed increased rates 10 times since then. In August, the CPI rose 0.6% to reach 3.7%.
These hikes weren’t only seen in the United States. The European Central Bank recently raised rates in the eurozone to 4%, with indications this could be the final increase after 10 rises in the past 14 months. Similarly, the Bank of England kept interest rates steady at 5.25% after 14 consecutive hikes. That came as a surprise due to a drop in the U.K.’s inflation to 6.7% in August. Since March last year, central banks in the UAE, Saudi Arabia, Bahrain and Kuwait also raised their benchmark rates in line with the U.S. Most GCC central banks follow the Fed’s rate changes due to their U.S. dollar peg, except for Kuwait, which uses a currency basket.
Ted Rossman, a senior industry analyst at Bankrate.com, observed that the Fed’s focus remains on maintaining elevated interest rates while inflation, though slowing, remains high. He highlighted that consumers will experience ongoing price increases, albeit at a reduced pace. These elevated rates affect loans, credit cards, mortgages and savings, increasing the cost of borrowing.
How Interest Rates and Inflation Are Connected
When the Federal Reserve raises the federal funds rate in response to high inflation risks, it boosts risk-free reserves in the financial system, reducing the money supply for riskier assets. Conversely, when a central bank lowers interest rates, it increases the money supply for risk assets.
Higher interest rates deter consumer and business spending, especially on big-ticket items like housing and capital equipment. They also impact asset prices and make banks more cautious about lending.
Why the Fed Keeps on Increasing Interest Rates
The Fed raises rates to limit consumer spending by increasing borrowing costs. The idea is that pricier goods may deter buyers, prompting sellers to reduce prices to attract customers. For instance, a car dealer might lower car prices if higher auto loan interest rates dissuade buyers.
The Fed aims to reduce inflation to 2%, but it’s a complex challenge. The central bank faces difficulties due to robust job gains, low unemployment, pandemic-related supply-demand imbalances, higher food and energy prices and the global economic impact of Russia’s war in Ukraine — all contributing to high inflation.
Several challenges, including semiconductor and labor shortages, affect consumer behavior and the economy. The Fed can influence borrowing but can’t fix supply issues. Addressing these constraints may require a significant drop in demand, which could trigger a recession and more job losses.
Despite other policy options for managing inflation, the Fed favors interest rate hikes due to their quicker impact. Elected leaders have tools like tax increases but face resistance and time delays when implementing them.
Can Interest Rates Control Inflation?
Policymakers react to economic shifts with a time delay, and their decisions take time to impact inflation. Therefore, they must predict future inflation trends while relying on past data, which can vary due to temporary or lasting economic shocks.
Interest rates and inflation trends align — but with delays. Policymakers rely on data to gauge future inflation and rate adjustments take time to impact the economy. Rising rates may curb inflation, while a slowdown may prompt rate cuts. The Fed influences the federal funds rate, in part, by determining the rate on banking reserve balances.
Final Thoughts
As interest rates rise, consumers should explore options like refinancing existing debt or taking advantage of promotional 0% APR credit cards. Consider how different rate moves affect your financial goals before taking action. Although inflation remains high, the Federal Reserve is managing it carefully to avoid recession risks. Long term, mitigating inflation requires comprehensive measures like addressing supply issues and implementing sustainable economic policies.
However, if the Fed continues to increase rates, it may eventually slow down economic growth and impact consumer spending. Pay attention to interest rate hikes and their potential impact on your financial decisions. Stay informed and consider seeking professional financial advice if needed.
On the date of publication, Chris MacDonald did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
