The Federal Reserve Bank of New York, whose Introduction to Interest Rates is recommended by the United States Department of the Treasury, defines interest as, “the price that someone pays for the temporary use of someone else’s funds.” An interest rate is an agreed-upon price for the use of those funds, typically expressed as a percent per year that the debt remains outstanding. The United States Department of Labor defines inflation as, “the overall general upward price movement of goods and services in an economy,” and rates of inflation are measured and reported by the Bureau of Labor Statistics. Inflation is driven by supply and demand: if manufacturers produce more goods than consumers are willing to buy, the supply exceeds the demand, and the cost of goods goes down; whereas, if manufacturers cannot supply the consumer demand, prices increase, resulting in inflation. So, how are interest rates and inflation related to one another, and what do they mean to your wallet?
Interest rates are established by the Federal Reserve, which is commonly called the Fed. The Fed sets the target for the federal fund rate, which is the interest rate that banks must pay to borrow money. This in turn drives the interest rates that banks charge you to buy a house, buy a car, or use a credit card. The lower rate, the easier it is for you to buy the things you want. The higher the rate, the less you can afford.
So, what drives the monetary policy that the Fed uses to set that federal fund rate? The answer is inflation.
Economics are tricky, complicated business, and few economists agree on all the calculations and influences. However, a simple example can give some insight to how inflation drives the federal fund rate. Imagine you work for an auto manufacturer. As the price of cars increases over time, by way that phenomenon known as inflation, it gets harder for you to afford that car you want. But at the same time, the auto manufacturer is making more money on those cars and can afford to pay you more. In a healthy economy, wages increase at the same rate that the cost of goods increases. Now, imagine that as the price of vehicles goes up, so does the price of health care. As a result, your employer cannot afford to divert the excess sales into your paycheck, because the funds are required to maintain your health care benefits. In this scenario, the economy suffers, because wages do not keep up with inflation.
This is where the Fed comes in. Although the U.S. economy has global influences that are outside of its government’s control, the Fed can have an impact by lowering the federal fund rate. By doing so, the government gives consumers more spending power to compensate for wages not keeping up with inflation. Consumers can buy more goods, because they are spending less on debt interest. Likewise, businesses can borrow money for equipment, which allows manufacturers to make their operations more efficient, which in turn boosts the overall economy.
Inflation and interest rates have a relationship outside of that enforced by the Fed, as well. Interest rates are affected by inflation due to supply and demand of credit. In a healthy economy, consumers earn higher wages, allowing them to spend more, and the demand for credit increases, driving interest rates up. On the other hand, a recession forces consumers to spend less, driving down the demand for credit, and subsequently, interest rates.
Interest rates and inflation are closely related drivers of the overall U.S. economy. In the end, both are determined by the law of supply and demand, and both have an impact on your wallet.