The Relationship Between Inflation & Bank Interest Rates

One of the most important jobs of a nation’s central banking system is keeping the growth of inflation at a manageable rate. This keeps prices within reach of the average worker’s wages. In the United States, the Federal Reserve System serves as the national central banking system. Due to the correlation between inflation and interest rates, one of the most important ways the Federal Reserve promotes the nation’s economic health is by using interest rates to make sure inflation is moderate.

A steadily rising rate of inflation isn’t a bad thing. It’s often the sign of a growing economy and an incentive for investors. Problems begin when inflation rises too rapidly and the wages of many consumers can’t keep up with prices. Left unchecked, spiraling inflation can badly damage a nation’s economy and even devalue its currency.

Banks and other lenders can affect inflation by changing the availability of money for borrowing. When interest rates are high, it costs more to borrow money. Expensive loans discourage both consumers and corporations from borrowing for big-ticket purchases, causing demand to drop and prices to fall. Inflation is lowered. Conversely, spending is encouraged by low interest rates. When money is plentiful and can be borrowed cheaply, the demand for goods increases and prices and inflation also rise.

The Federal Reserve works to control inflation by setting the interest rate for the nation’s banking system, also known as the federal funds rate. This is the interest rate banks use when they lend their excess reserves to each other. Because the U.S. economy is so large, changes to the federal funds rate can impact financial markets around the world. Although they are not required by law to do so, most large banks in the U.S. use the federal funds rate to set their prime rate, which is the base interest rate offered to businesses and consumers for many types of loans. The prime rate ensures that borrowers pay slightly more in interest than banks pay when they have to borrow.

The current inflation rate isn’t the only factor the Federal Reserve takes into account when determining if interest rates need to be raised or lowered. Inflation is just one aspect of the monetary policy the Federal Reserve has been charged by Congress with enacting. The goal of the policy is to guide the nation’s economy over time toward a growth rate that ensures safe expansion.

Rising inflation can have a devastating effect on employment because it slows economic growth. When individuals and companies hold onto money rather than spending it, the number of jobs will eventually shrink and unemployment will rise. During times of high unemployment, wages typically remain steady and spending is slowed even more. In a growing economy, the demand for workers can create a tight labor market and drive up wages. This can push prices for goods and services higher and result in higher inflation.

The Federal Open Market Committee (FMOC), which is the branch of the Federal Reserve that defines monetary policy for the system, has set 2 percent as the annual inflation rate that supports economic stability and maximum employment for the nation. The rate is measured by the change in the annual price index for personal expenses. According to the FMOC, a rate lower than 2 percent could mean that prices and wages are falling, the sign of a weak economy. A higher rate of inflation is undesirable because it makes it harder for investors and borrowers to make long-term financial decisions.