Basics of Inflation Affecting Interest Rates
- When the economy is in a growth or expansionary phase, wages and consumer spending are increasing. As consumers spend more money, the prices of goods and services tend to increase, often referred to as upward price pressure. This pressure then leads to increased inflation, creating a negative economic cycle of increased consumer spending begetting increased inflation. If this cycle becomes unsustainable, meaning that consumers are no longer willing or can no longer afford to pay the increase in prices, interest rates tend to increase.
- An increase in interest rates causes loan payments to increase, meaning, it becomes more expensive for businesses and consumers to take out loans. This then translates into both businesses and consumers taking out fewer loans, which leads to a reduction in consumer spending. This then leads to a slowing of the rate of inflation. The goal of this type of interest rate increase is to stabilize economic growth to a more sustainable rate.
- Just because the economy is in a downturn does not mean that inflation is not increasing. It does mean however, that consumer spending is down. The decrease in consumer spending is because of the increase in the unemployment rate during a downturn. This increase in unemployment leads to a decrease in disposable income. This then leads to a decrease in consumer spending. When the economy is in a downturn, the overall state of the economy may have more of a bearing than the inflation rate regarding the FOMCs decision to increase or decrease interest rates.
- In a downturn, the goal of the federal government is to help the economy grow, so the FOMC typically decides to lower the federal funds rate. Banks then tend to lower their interest rates on loans in the hopes that consumers and businesses will take advantage of the lower interest rates by taking out more loans. When consumers and businesses take out more loans, it increases consumer spending and, hopefully, puts the economy back into a growing trend.
