Interest Rates and Inflation: How Are the Two Related?

It was less than four years ago when interest rates were at historic lows and refinancing mortgages was the main topic of conversation. But how are interest rates determined? And how does inflation affect interest rates?

The “Fed” or Federal Reserve Board sets a target for the Fed Funds rate. This is the rate of interest that banks are charged when they borrow money from the Fed. They in turn use that money to make loans to their customers. When the Fed Funds rate is low, they can lower the interest rate charged for mortgages, loans, or credit cards. Conversely, when the Fed raises the rate, the banks then increase the interest rates charged to their customers.

The Fed Funds rate reached an all-time high of 20% in December 1980 and the lowest was effectively 0% in 2008 and 2020. Today, the Fed Funds rate is about 5%. The year 2008 was when the financial crisis began and 2020 brought us the Covid pandemic. Both crises forced the Fed to lower interest rates to help stimulate economic growth. At the same time, they were increasing the money supply to banks so that it would be easier for banks to make loans to their customers. Individuals started spending more and companies borrowed more to invest in their businesses. This strategy helps economic growth but sometimes the economy can grow faster than usual, and inflation ensues.

After the Covid pandemic, inflation increased to about 9% because of the shortage of goods and services. Prices for everything from eggs and bread to gas went up. The only remedy the Fed had was to raise interest rates to slow down spending and consumption. It was painful as mortgage and loan rates increased, but it worked. Within two years, the inflation rate came down to about 3.9%. The Federal Reserve Board now has a target rate of 2% for inflation. There is still a way to go to meet their goal, but in the meantime, they have signaled that although inflation is coming down, they will be cautious about lowering the Fed Funds rate too quickly so as not to reignite inflation.